Nobody will fault you for front-loading your retirement contributions, but be aware of the limitations.
Your employer-sponsored retirement plan — for most, it’s a 401(k) — is one of your more important tools as a retirement saver. With a 401(k), 403(b), or 457 plan, you have the opportunity to contribute current income and take advantage of tax-deferred growth. If you’re fortunate, your employer will also offer a matching contribution up to a certain share of your compensation. There are, however, a number of downsides to contributing the annual maximum ($19,500 in 2021).
1. You’ll have less cash at the ready
More money allocated to your 401(k) is great for the long-term trajectory of your overall net worth, no doubt. But make sure you have enough cash on hand to fund ongoing expenses as well as an emergency fund containing liquid reserves. If you devote too much money to your 401(k), you may be giving up the ability to save for a down payment or to cover unexpected expenses. Although you have the option of taking out a 401(k) loan in the future, this is really not an advisable strategy.
2. The money is locked away
Once you’ve set aside money in your 401(k), don’t plan to use it in the near future. If you want to withdraw 401(k) funds before you’re 59-and-a-half, you’ll incur a 10% penalty in addition to ordinary income tax on the amount withdrawn. That’s why the money should really be considered long-term savings for retirement costs — not for immediate or mid-life expenditures. While a 10% penalty won’t cripple your portfolio, it’s completely avoidable with diligent financial planning.
3. A large 401(k) is substantially taxed
Remember that if you have a very large 401(k) balance in the future — a good thing, all things considered — a substantial portion of the account will ultimately be paid out as income tax. This reveals two of the drawbacks of having heavy balances in tax-deferred accounts: One, the accounts contain significant tax liability, and two, 401(k) withdrawals can have the effect of pushing you into a higher tax bracket in retirement. Furthermore, 401(k) accounts come with the promise of Required Minimum Distributions (RMDs) upon your 72nd birthday, another wrinkle that increases your future taxable income.
4. High fees
Some, but not all, employer-sponsored plans come with very high fees. These can come in the form of administrative charges or abnormally high expenses levied on the underlying plan investments. If you continue to stay with the same employer for a long period of time, you could be exposed to these substantial fees — and sometimes, you may not realize it without doing a bit of digging. High fees are another reason to thoroughly investigate your company’s 401(k) plan document and related investment menu. If the fees do turn out to be high, you might consider diverting money elsewhere once you’ve contributed enough to get your employer match — if you’re lucky enough to have one.
5. No employer match
If your employer isn’t matching your contributions at any level, it may be time to rethink making outsized allocations to the plan. An employer match refers to the company’s contribution to the plan on top of your contribution, up to a specified amount of your compensation. The match acts as a further incentive to contribute to the plan. Depending on your knowledge of other retirement savings vehicles, like a Roth IRA, for example, and your desire to keep more cash on hand, you might not want to max out your 401(k) plan if there’s no employer match.
Know what you give up
Again, a 401(k) is a powerful wealth-building tool that will help you save for retirement. Compound growth will take hold at a young age, so consistent and meaningful contributions will most definitely increase your net worth over the long term. Still, it’s important to remember that no retirement vehicle is perfect, so be sure to understand where the 401(k) falls short and how to know if your particular employer-sponsored plan isn’t all it’s cracked up to be.