Should you max out your 401k? Here’s why I'm not maxing out my 401k

Since starting my first “adult” job out of college, I followed the mainstream advice of maxing out my (traditional) 401k each year. Avoiding income tax on money that you’re going to save anyways is an obvious win, right? I have always thought so, until recently when I came across Nick Maggiulli's article titled Why You Shouldn’t Max Out Your 401(k).

I ran some scenarios for myself and concluded that 1) given my goal of reaching financial independence in my 30s and 2) given I have already saved up a decent amount in my retirement accounts, it would actually make more sense for me to only contribute to my 401k up to my employer’s match. Read on for my numbers and to see if this strategy is right for you, as I suspect it also applies to many other young savers aiming to reach financial independence earlier in life.

Before I continue, I want to highlight that no matter what your financial plan, you should always contribute to your 401k up to your employer match if you have the ability to do so. By doing this you instantly earn a 100% return on your contribution even before any investment growth.

Comparing 401(k) types

Before getting into the numbers, let’s lay some ground rules about the two different types of 401k plans. Both the Roth 401k and traditional 401k are employer-sponsored and for the most part lock up your money until age 59.5. With a Roth 401k, you make after-tax contributions to your account which grow tax-free until age 59.5 at which point you can also withdraw funds tax-free. With a traditional 401k, you make pre-tax contributions to your account, which reduces your taxable income when you make the contribution, however when you make withdrawals after age 59.5, your withdrawals are taxed as ordinary income. You are essentially choosing between paying taxes on the front end when you make your contribution (Roth) or on the back end when you make your withdrawal (traditional).

The Roth makes more sense if you expect your income tax rate to be higher in retirement than right now, and the traditional option wins if you expect your tax rate to be lower in retirement. Since I plan to have a lower income in retirement and thus a lower tax rate, I’m going to focus on the traditional 401k side.

How I calculated the potential benefit of maxing out my 401k

To decide whether I should max out my traditional 401k or not, I ran the numbers on two different scenarios where I would contribute or invest the money this year and follow the money along both paths until I withdraw it at age 60.

Both scenarios assume:

  • Base salary of $115,000
  • 4% company 401k match
  • $50,000 per year spending in retirement
  • Current tax residence: California
  • Retirement tax residence: Arizona
  • 5% investment growth rate

Scenario 1: Max out 401k

  • My 401k contribution: $20,500
  • Company 401k contribution: $4,600

Scenario 2: Only max out 401k up to company match, put the rest in a taxable brokerage

  • My 401k contribution: 4,600
  • Company contribution: 4,600
  • Amount left to contribute towards taxable brokerage: $10,812. This represents the difference of $20,500 - $4,600 after taxes.
  • Dividend yield of 1.3%, reinvested
  • Capital gains tax of 15% is paid on dividends each year

Now to compare the two scenarios, I used a starting value of $15,900 for #1 and $10,812 for #2, since the company match and my contribution up to the match cancel out between the two.

After running the numbers, at age 60:

  • The 401k withdrawal is worth about $69,000 after paying ordinary income tax (using the tax rate for a $53,000 annual income for fair comparison).
  • The taxable brokerage withdrawal is worth about $53,000 after paying an effective capital gains tax rate of 6.6%.

You can find my calculations in this Google sheet.

Takeaways

Overall the 401k performs about 0.9% better than the brokerage on an annualized basis. Another way to think about this is that the cost for me to have access to a large chunk of my net worth before age 60 is 1% growth per year. This also assumes that:

  • I have identical investment options in both accounts, which is unlikely to be the case as I will not be able to choose my 401k provider. Higher index fund fees could quickly erase the 401k’s edge.
  • Ordinary income taxes do not rise in the next 25 years. Given the trend in government spending, it seems more likely than not that ordinary income taxes will rise faster than capital gains taxes in the future.

In addition to these factors, I already have a decent amount in my retirement funds from saving early in my career. At age 26, I have $164,000 saved between my 401k, traditional IRA, and Roth IRA. If I only contribute up to the employer match for the next five years, then by age 60, these retirement accounts will total between $1 to $2 million assuming an investment growth rate between 5% and 7%.

If you want to be financially free in your 30’s, you’re going to need as much in accessible, taxable accounts as possible, and only contributing up to your employer’s 401k match will help with this.

Buying real estate is also top of mind for many young savers, and having more accessible savings is helpful to come up with ever growing down payments. Buying a property also gives you the option to house hack with roommates or Airbnb as well as take advantage of appreciation with leverage.

If you made it this far, I’d love to hear your thoughts about maxing out your own 401k. Should I make a web calculator to play around and compare different 401k contribution scenarios?