Should You Max Out Your 401k?

Someone inquired why a friend of theirs who is a 401(k) participant who was auto-enrolled at a 3% contribution rate has stayed at 3% instead of maxing out their contributions. The stereotype is that everyone should max out their 401k contributions.

Benefits in favor of 401K’s:

  • Asset protect from lawsuits, depending on complex rules
  • Encourages people to avoid spending their savings
  • Encourages people to save for retirement
  • Shift income into future years when retired when maybe in a lower tax bracket

Reasons against 401k contributions:

  • Retirement accounts create problems including double taxation of them at up to 85% for people wealthy enough to have to pay estate tax
  • People who want to start a business or buy a home (large down payments may be required in today’s tight lending standards) need access to their funds (although there are some restrictive work-arounds to this that may be available)
  • If long term capital gains or U.S. Treasury income (U.S. Treasury interest is free of state income tax) is generated in a tax deferred retirement account they lose their special tax status and when withdrawn from the account they are taxed as ordinary income
  • Capital Gains tax is waived by using basis step-up at death for assets in a taxable account but not in a retirement account

Of course if someone can get an employer match they should participate to get it. Probably the simplest explanation why someone contributed 3% is that they were too poor to save. For a person who is in a 15% tax bracket the tax savings is not that appealing as simply getting enough current spendable income to buy the basic staples, assuming they are a low income person.

Generally the reasons against a 401k are only applicable to people wealthy enough to pay estate tax. But with inflation and a need to raise taxes it is possible that in a few decades people who are middle class will have the potential to come close to paying estate tax. That would depend on how long they live and what excessive medical costs they encounter, assuming Medicare in the distant future has huge “means testing” fees.

About the author

Don Martin, CFP®

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