The Unfortunate Truth About Maxing Out Your 401(k)

If you have a 401(k) plan available to you at your workplace and you're participating in it, routing a certain percentage of each paycheck to your 401(k) account regularly, that's great! Those tax-advantaged accounts can really help people save for retirement.

But 401(k) plans aren't perfect, and you may want to think twice before maxing out contributions to your 401(k) account. Here are some reasons why.

Start Your Mornings Smarter! Wake up with Breakfast news in your inbox every market day. Sign Up For Free »

Image source: Getty Images.

Some 401(k) basics -- tax breaks and contribution limits

Employer-sponsored 401(k)s come in two main varieties: traditional and Roth, just as there are traditional and Roth IRAs.

With a traditional 401(k) or a traditional IRA, you typically get an upfront tax break: Whatever sum you contribute for a certain tax year can be deducted from your taxable income for that year.

With a Roth 401(k) or a Roth IRA, your contributions are made with after-tax money. You get no upfront tax break, but if you follow the rules, you can eventually withdraw money from your Roth account tax-free! If you manage to accumulate hundreds of thousands of dollars worth on investments in a Roth account, imagine being able to withdraw it all tax-free in the future -- that's a powerful benefit!

Another key thing to know about these accounts is that they have annual contribution limits -- and those for 401(k)s are far larger than those for IRAs. For 2025, the 401(k) contribution limit is $23,500, with an additional $7,500 "catch-up" contribution allowed for those 50 or older -- totaling $31,000. Thanks to the SECURE 2.0 Act, some older folks get an even bigger catch-up contribution: Those aged 60 to 63 by the end of 2025 can contribute an extra $11,250 in 2025, for a grand total of $34,750.

The IRA contribution limit for 2025 is $7,000 -- or $8,000 if you're 50 or older. (Note that if you have several IRA accounts, this limit is for all of them, so you can contribute $5,000 to one and $2,000 to another, but not $7,000 to each.)

Why not max out that 401(k)?

Clearly, with such steep contribution limits, 401(k) accounts can really help you sock away big sums for your future. But understand and consider a few things before doing so:

• You can have and contribute to both a 401(k) account and one or more IRA accounts. This isn't an either-or situation.
• Many 401(k) accounts feature matching contributions from the sponsoring employer. This is essentially free money, so it's smart to at least contribute enough to your account to grab all available dollars.
• IRAs give you much more flexibility when it comes to what you can invest in within the account. An IRA at a good brokerage will typically permit you to invest in most stocks and most mutual funds, too. A 401(k) will typically offer you a rather limited menu of funds, perhaps featuring several target-date funds.
• A limited menu of funds can be OK, if, say, it includes one or more low-fee, broad-market index funds such as one that tracks the S&P 500. Such funds can really be all you need to build long-term wealth. (Do check out the fees involved, though -- if they're higher than they should be, maybe don't sock too much into those funds or look for lower-fee ones.)
• A 401(k) account will often start you off with some default investments. Make sure they're what you want -- or swap them for some other, better funds on offer.
• There are rules regarding when you can start withdrawing money without penalties from 401(k)s and IRAs.

Have a strategy

Given all that, the best approach is to have a strategy. Weigh your options while keeping your needs and preferences in mind. For example, with your money available for saving and investing:

• Make sure you have an emergency fund ready with at least a few months' worth of all non-negotiable living expenses.
• Pay off any high-interest rate debt, such as that from credit cards.
• Contribute enough to your 401(k) to max out all available matching funds.
• Then consider sending your next dollars to one or more IRAs, where you can invest in a wider range of investments. You might even just invest in low-fee index funds in those accounts -- such as the Vanguard S&P 500 ETF (NYSEMKT: VOO).
• Once you max out your IRA contributions, you could devote your next dollars to your 401(k) account again -- or just invest for your future in a regular, taxable brokerage account.
• If you're eligible, consider investing in a health savings account (HSA), too, as it can help you pay for approved health costs and can also serve as a retirement savings account.

So don't automatically aim to max out contributions to your 401(k) without considering other uses for some of that money. You might want to invest some dollars elsewhere or use it to strengthen your financial health in other ways.

The $22,924 Social Security bonus most retirees completely overlook

If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $22,924 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.

View the "Social Security secrets" »

The Motley Fool has a disclosure policy.