Should you max out your 401k?

Let’s say your employer provides a 401(k). Should you max out your 401(K)? Only contribute to the extent your employer matches? Or something else? And what if your employer doesn’t have a match at all? There’s not one correct answer.

Here’s how it works

For starters, here’s how the 401(k) works and why you should probably take advantage of it if you have you available to you.

Let’s say your salary is $100,000. For simplicity, let’s say you are single, paid bi-weekly, and select one allowance on your W-4.

Here’s what your hypothetical take home pay per paycheck and for the year might look like:

When you contribute to a 401(k), you take part of your income and place it in the 401(k) to be invested. That amount is deducted from your gross pay, reducing the amount of taxes you owe.

Here’s what your paycheck would look like if you contributed 10% of your paycheck to your 401(k):

	No 401k Contribution	10% 401k Contribution	Difference
Gross Pay	$100,000	$100,000
401(k) Contribution	$0	$10,000
Federal Income Taxes	$23,684	$20,261	$3,423
Social Security Taxes	$6,200	$6,200
Medicare Taxes	$1,450	$1,450
Total Taxes	$31,334	$27,911	$3,423
Take Home Salary	$68,666	$62,089	$6,577

So, you contributed $10,000 to your 401(k), reducing your take home pay by $10,000. But you also reduced your total taxes due by $3,423. So, you only reduced your take home pay by a net of $6,577. That’s the benefit of the pre-tax 401(k) contribution!

Side note: your 401(k) contribution reduces your federal income taxes due, but not your Social Security or Medicare taxes.

So, you made a contribution to your 401(k) and reduced your take home pay by $6,577. That’s okay, because your $10,000 will sit in your 401(k) and you’ll invest it. If you did that every year until you retire (let’s say that’s 30 years from now and your portfolio grew at a conservative 3%), it would be over $500,000. (Hopefully you’ll invest more as you age and invest more aggressively)

How much should you contribute?

Here’s a question I get a lot. How much should you invest? Should you max out? Or just contribute up to your employer’s match? There’s no correct answer, but here are something to think about.

Let’s stay with the hypothetical above where your salary is $100,000 and you contribute 10%. Let’s say your employer matches 50% of your contributions up to 5% of your salary. In this case, you would contribute $10,000 and your employer would match $5,000. Iff you contribute 15% your contribution would be $15,000 and your employer would still match only $5,000.

So, how much should you contribute?

Some people would say just contribute up to your match, no more. Why contribute more if you don’t get a match? Well, as we saw above your 401(k) contributions reduce your federal income taxes. Plus, you don’t pay any tax on the money that’s invested in your 401(k).

The match is great, but the goal of a 401(k) is to help you build a retirement nest egg. If you can, I’d argue that you should take advantage of the tax deferral and grow your retirement nest egg as much as possible. That’s still true even if your employer doesn’t match at all.

What if you need more take home pay?

However, don’t make the mistake of maxing out your 401(k) contributions because you heard that it’s the common wisdom and leave yourself without enough take home pay. You don’t want to have to liquidate other savings or investments to pay monthly expenses, potentially paying capital gains taxes, because you haven’t left your self enough after your 401(k) contribution.

If you think you may be in that situation, start with a plan. Estimate how much you need each month. Take your last paycheck, and estimate how much you’d have to scale back your 401(k) contribution to meet your monthly obligations. Then, think about your investment plan. Should you be taking more risk or less? How much depends on your age, retirement expectation, and other factors.

Here’s the bottom line: maxing out your 401(k) should be balanced against your current spending needs. Maxing out your 401(k) and investing aggressively is a great way to boost your retirement nest egg. But you should do so with a financial plan in mind.