Key Points

  • Investors should be aware of fees and taxes before maxing out their 401(k).
  • The costs of joining a 401(k) plan could not be offset by the tax advantages.
  • It takes consideration to decide whether to max out your 401(k).

It's usually a good idea to save a lot of money, but there can be better alternatives.
The Sad Reality of Maxing Out Your 401(k)

You're in a great position if you can contribute the maximum to your 401(k). Saving $20,500 for retirement this year is no easy task. And while it's generally a good idea to put as much money as you can into a tax-protected retirement account, there are some drawbacks to this strategy.

The regrettable reality of maxing out your 401(k)

The standard 401(k) plan has numerous costs. These costs, which can be divided into administrative, investment, and service fees, pile up. Every year, the average large employer's 401(k) participant pays fees equal to 0.88 percent of their portfolio.

That is the cost of utilizing the tax benefits of a 401(k). To be more precise, a standard 401(k) shields assets from capital gains taxes and lets you deduct contributions from your income taxes for the year you make them.

That's a good deal in some circumstances, but not in others. The costs will wind up costing you a lot if you want to keep your money in the 401(k) for a long time. Furthermore, the tax savings are certainly worthwhile if you are a high earner with a wide disparity between your income and expenses. In retirement, you can probably keep your taxes significantly lower. To determine whether such costs are worthwhile, though, be careful to do the arithmetic and make some reasonable projections.

  • Using a standard brokerage account might be preferable for you.
Using a standard brokerage account is an alternative to fully funding your 401(k). Anything you save in your regular brokerage account will be subject to taxes, but it might be advantageous. This is especially true if you don't believe that your regular 401(k) investment will result in significant tax savings when it comes time to take distributions in retirement.

It's more likely that picking a taxable brokerage account would be preferable to a Roth alternative for a 401(k). Both contribute to the account with after-tax dollars. While a Roth will protect you from capital gains tax, the actual tax savings may not be significant. This is especially true if you have a high income. for a buy-and-hold investor.

For a single year, it's excellent if you can reduce your tax liability by 15% (the usual long-term capital gains tax rate). However, if you do it over the course of a 40-year career, the tax savings comes out to be roughly 0.375 percent annually. Additionally, there are strategies to lessen the capital gains tax's effects, so the actual tax savings can be less.

Keep in mind that the typical 401(k) has a cost of 0.88 percent. You would actually be paying more after taxes to save in a Roth 401(k) over the long term when you take into account that you can find comparable investment options with far lower costs in a taxable brokerage account.

A 401(k) investment effectively locks up your money until you reach retirement age. While the primary contributions to a Roth 401(k) are always accessible, none of the gains can be accessed without incurring a fee. Is that reduced flexibility worth the modest savings (if any) you would anticipate in the long run?

Maximizing your retirement funds

Unfortunately, it's not always a wise financial decision to max out your 401(k). Although it can undoubtedly result in tax savings, there is a price. These expenses are due to the rigidity of the account and fees related to the 401(k) plan.

Nevertheless, everyone should make a minimum contribution to qualify for their employer's matching contribution. Giving up the match is equivalent to reducing your compensation. The choice to continue contributing after the game calls for a far more thorough investigation.