What's the Unfortunate Truth About Maxing Out Your 401(k)?

The premise sounds fantastic: The more money you save for retirement during your working years, the bigger your retirement nest egg. And contributions to workplace retirement accounts can be tax-deductible, making it a little bit easier -- even if only for psychological reasons -- to divert a portion of your income into these vehicles.

If your plan is to max out your contributions to your 401(k) account for as long as you can, however, you might want to take a step back and reassess that idea. Getting hyper-aggressive with tucking money away in this type of retirement savings account comes with a downside (a handful of downsides, actually, although they all fit into one single category).

That is, 401(k) accounts are quite inflexible compared to your alternatives. Let's find out why -- and what you should do about it.

The potential downsides of tucking money away in a 401(k)

Don't misunderstand: 401(k) plans have distinct advantages. Chief among them is the amount of money you can contribute. For this year, every participant in such a plan can put up to $23,500 of their own earnings into one of these workplace retirement accounts, while people between the ages of 50 and 59, as well as 64 and older, can add another $7,500 (bringing the total up to $31,000). A lucky sliver of workers between the ages of 60 and 63 have the option of making a "super" catch-up contribution of $11,250, upping their maximum contribution for the year to $34,750.

And that's just the employee's portion of money put into a 401(k) account. Most employers also match some portion of workers' contributions toward their own retirement savings, up to as much as 6% of each employee's total income. A few lucky employees are even reaching this year's combined legal limit of $70,000 in total annual contributions to their 401(k) accounts.

Nevertheless, there are arguable downsides to making the most of your workplace retirement savings options. As noted, these vehicles can be quite inflexible -- in several ways.

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One of the drawbacks is the limited number of investment options you'll have within most 401(k) plans. In most cases these plans are administered by a mutual fund company, and in almost all cases you only have the option of investing in mutual funds -- not individual stocks.

This will likely work out fine for most people (a simple index fund is still arguably your best choice, or perhaps a target-date fund). But if you're able to consistently select the right stocks, your 401(k) account's performance might underperform your other investments.

Money held in a 401(k) account is also more difficult, and sometimes more costly, to access quickly than assets held in traditional IRAs, and certainly more so than money in a brokerage account.

Ideally, you wouldn't want to remove money from any of your retirement accounts before you're actually retired. Life happens, though. Sometimes unexpected expenses pop up, and you have to do what you have to do.

Although early withdrawals (before you reach age 59 1/2) from any non-Roth retirement accounts are almost always taxed as income and usually penalized an additional 10%, getting money out of a 401(k) account requires both time and a fair amount of paperwork. And in some cases your employer may first insist you take this distribution in the form of a loan, which you then pay back to yourself through payroll deductions, not necessarily solving your current financial problem.

In contrast, any assets or money in an ordinary IRA held at a brokerage firm like Charles Schwab or Fidelity can be turned into a check payable to you, often within just a couple of days. There's no hassle -- just a tax bill due by April 15 of the following year.

It's also worth mentioning that while there are some hardship exceptions that will exempt you from the 10% penalty for early 401(k) withdrawals, there are more for IRAs. Namely, 401(k) plans typically don't allow for penalty-free withdrawals for costs related to higher education, withdrawals of up to $10,000 to help fund the purchase of your first home, or medical insurance costs if you become unemployed. Both traditional and Roth IRAs offer all three.

In this vein, if maxing out your 401(k) would mean you have no short-term emergency fund whatsoever, you may well be better off in the long run keeping a little of your money liquid, just so you can buy yourself time to navigate an emergency without being forced to tap into a retirement account.

Finally, while the idea of lowering your taxable income right now -- by making tax-deductible contributions to a tax-deferring vehicle -- sounds great on the surface, it's not necessarily the best choice for you. You may be better off with a Roth 401(k) that doesn't offer you a tax break while contributing, but does offer you tax-free withdrawals in retirement.

Broadly speaking, you'll want to pay income taxes on your retirement savings whenever your taxable income is at its lowest, and avoid income taxes when your income is at its highest. That might be now, but it could be later.

The only problem? Not every employer offers a Roth 401(k) option. Mutual fund giant and retirement plan administrator Vanguard reports that as of the end of last year, only 86% of the companies whose retirement plans it manages provide access to Roth 401(k) accounts. If a Roth is your best choice, maxing out contributions to a non-Roth 401(k) will only make matters even more financially challenging for you in the long run.

Most people will want to do a little of both

Don't view the comparison of your retirement savings options through an extreme "either/or" lens. Most likely, you'll want to use a hybrid approach that combines saving in a 401(k) account with saving in an IRA; this combo approach may also meld Roth and non-Roth retirement savings vehicles.

The chief priority in any savings strategy is to put enough into your 401(k) to ensure that you qualify for the biggest matching contribution your employer is willing to make. That really is free money, once you're vested. After that, where you save becomes a judgment call based on your particular plan and projections.

Just be sure to save as much as you feasibly can without limiting your access to cash, no matter how and where you save for retirement.

Charles Schwab is an advertising partner of Motley Fool Money. James Brumley has no position in any of the stocks mentioned. The Motley Fool recommends Charles Schwab and recommends the following options: short December 2025 $95 calls on Charles Schwab. The Motley Fool has a disclosure policy.