Here’s Why Retirement Savers Should Think Twice About Maxing Out a 401(k)

If you have access to a 401(k) plan through your employer, you may be inclined to contribute as much money as possible to it. With a traditional 401(k), the more you invest, the more income you can shelter from taxes, up to the annual IRS limit.

In addition, many 401(k) plans offer an employer match. So if you contribute enough to yours, you can collect a bunch of free money on top of that.

Image source: Getty Images.

It generally makes sense to fund your 401(k) plan up to the matching amount your company is willing to give. So if your employer matches contributions of up to $3,000, you should consider putting that much into their plan.

But you might not want to max out your 401(k), which, this year, means investing $23,000 if you’re under 50 or $30,500 if you’re 50 or older. You may find that another retirement savings plan serves your needs better.

An IRA could offer more investment options and save you money on fees

A major disadvantage of 401(k) plans is that they don’t allow you to invest for retirement in individual stocks. Rather, you’re generally limited to a wide range of funds, from target-date funds that are suitable for non-trading investors to mutual and index funds.

The problem with this is twofold. First, by limiting you to investment funds, 401(k)s make it difficult to build a customized retirement portfolio. This could limit the growth of your savings.

Also, target-date funds and mutual funds are notorious for charging high fees, known as expense ratios, that can destroy your 401(k)’s return over time. While you can generally avoid this problem by sticking to lower-cost index funds, you may not find an index fund you’re happy with depending on your plan choices.

The nice thing about IRAs is that they give you more options for investing your savings. If you want to handpick a stock portfolio based on your own research, you can. This could lead to a portfolio with returns that outperform the broad market, leading to more wealth for retirement. And an IRA can also help you reduce unwanted investment fees.

An HSA can give you several tax advantages

While a 401(k) plan allows you to shield contributions from taxes (assuming you have the traditional type, not a Roth), an HSA gives you that benefit plus two others. HSA funds can be invested for tax-free earnings, and HSA withdrawals used for qualified medical expenses are tax-free.

It’s worth noting that an HSA is not strictly a retirement savings plan. You can make an HSA withdrawal at any age or stage of life to pay for medical expenses. But because HSAs don’t require you to withdraw your money within a specific time frame, you have the option of setting aside your balance for retirement, when health care costs might be the highest.

You should also know that once you turn 65, you can make an HSA withdrawal for non-medical reasons without facing a penalty. This allows you to treat your HSA as a backup savings plan for general expenses. However, non-medical HSA withdrawals at age 65 or later are subject to taxes. If you want your HSA funds to be tax-free, you’ll need to use the money for eligible healthcare costs.

There’s nothing wrong with funding a 401(k) plan with just enough money to get free money in the form of an employer match. But before you decide you’re going to try to max out your 401(k), consider putting some of your savings into an IRA or HSA — or both.