Should I max out my 401(k) or invest my money?

When planning your retirement savings, you have many options, including:

• Roth individual retirement accounts (IRAs)

• Traditional IRAs 

• The stock market and more

Another common retirement account is the 401(k), which employers usually offer.

Because of their convenience and benefits, these tax-advantaged accounts can be a smart retirement vehicle, but is it worthwhile to max out a 401(k) account? We explore this topic and offer some alternatives below. 

What does it mean to max out your 401(k)

With a 401(k), IRS laws limit yearly employee contributions. As of 2021, the annual limit is $19,500. If you're over 50 years old, you're permitted a $6,500 catch-up contribution that brings the annual contribution limit to $26,000. In 2022, these limits will increase to $20,500 and $27,000, respectively. 

Why you should max out your 401(k)

There's a handful of great reasons to max out your 401(k). 

Employer match 

Most employers offer matching contributions to your 401(k) up to a certain percentage of your salary. So, if your employer offers to match 100% of your contributions up to 6% of your $50,000-per-year salary, this would add up to $3,000 in free money every year. 

On top of that, the company match also earns interest along with the rest of your 401(k) balance. 

Tax-deferred growth

You make 401(k) contributions with pre-tax dollars; therefore, you have a reduced tax burden every payday.

For example, if your weekly check is $1,000 and you pay 15% in federal income tax, you'd normally be on the hook for $150 in federal income taxes. 

However, if you put $100 into a 401(k) retirement savings each payday, your taxable income would be only $900, so your federal tax for each check would only be $135.

Ongoing tax benefits

The initial tax benefits are great, but 401(k) accounts are tax-advantaged. Over the long term, they grow tax-free until you begin withdrawals. 

At that point, you start paying taxes on your withdrawals. But, your income is likely lower in retirement, so there's a good chance you're in a lower tax bracket when you start paying income tax on the money. 

Less temptation to spend

When you put money into a 401(k), it can be hard to get it out before retirement. An early withdrawal means hefty fees and penalties, except for a few specific situations, such as withdrawing money to buy your first home or paying for college.

These penalties help reduce the temptation to dip into your retirement plans for spending cash. 

Compounding interest

When your 401(k) account grows due to interest, you can reinvest it. This is called compound interest and plays a big role in building a healthy retirement account. 

The more money you put in your 401(k), the more opportunity there is to earn interest and compound it. 

Why you may invest

There are good reasons to max out your 401(k), but it's not ideal for every situation. Here are some reasons you may choose to invest outside of your 401(k) instead.

Remember, investing in stocks always comes with the risk of losing your entire investment, so it’s best to consult a financial advisor.  

Accessible funds

When you invest in the stock market, you can always liquidate the investments in your brokerage account relatively quickly for extra cash. Plus, there are no penalties for doing so. 

No limits on contributions

Unlike annual limits on 401(k) contributions, when you invest in the stock market, your budget is the only thing limiting the maximum amount you can invest.

More growth opportunity

For about the last century, the stock market has delivered a 10% return on investment. Of course, this varies greatly year by year. 

The average 401(k), with 60% invested in stocks and 40% in bonds, returns 5% to 8%. That may not sound like a huge difference, but it can make a big difference in the long term. 

Of course, these are purely benchmarking estimates, and results may vary.

More control over investments

With a brokerage account, you have more investment options. This means if there is a particular stock you think will heat up, you can quickly snap up a few shares. You can control what stocks and bonds you purchase and sell with the guidance of a financial advisor. 

With a 401(k), you generally choose a plan type based on your risk tolerance, and the investments are handled behind the scenes.

What to do after maxing out your 401(k)

If you max out your 401(k) and still have some free cash left in your budget, here are some ideas for the extra cash that can help diversify your portfolio and help you reach or even exceed your retirement goals. 

Open a Roth IRA 

A Roth IRA is similar to a 401(k), but you own the account instead of your employer, and you fund it with post-tax dollars. Also, with a Roth IRA, money grows tax-free, and qualified withdrawals are tax- and penalty-free. 

The downside to a Roth IRA is it has a lower annual contribution limit compared to a 401(k). For example, the 2021 and 2022 Roth IRA contribution limit is $6,000 if you're under 50 years old or $7,000 if you're over 50. 

Open a brokerage account

You can invest in a brokerage account to stretch your retirement savings and reach your financial goals. Always consult with an investment professional or a certified financial planner when getting into stocks, as there is the potential to lose your entire investment. 

Invest in your health savings account (HSA)

If you have a high-deductible health plan (HDHP), you may be eligible to open an HSA. An HSA is a savings account where you place funds for future out-of-pocket medical costs. You can invest up to $3,650 into this account per year as an individual or $7,300 as a family, and it is tax-deductible, like 401(k) contributions. 

Some HSAs also have an investment option, where you can set a specific amount to invest into various funds, just like a 401(k), and potentially earn interest. You can set a specific level in which your HSA automatically transfers into the investment account too. For example, if your HSA exceeds $2,000, you can have it automatically invest anything over the $2,000 mark. 

If you get sick and need to dip into this investment account, money automatically transfers from the investment account back to your HSA to cover the out-of-pocket expenses.

Plus, like a 401(k), your HSA may come with employer contributions. For example, an employer may contribute $250 per quarter for a family plan or $125 per quarter for an individual plan. 

Finally, and most importantly, once you turn 65 years old, you can take distributions from your HSA for any reason. This effectively converts it into another 401(k) later in life. Before this, any nonmedical withdrawals are subject to a 20% penalty, plus income tax. 

Max out your 401(k) and reach your retirement goals

Should you max out your 401(k)? If your financial situation allows it, it’s worth considering. There are many benefits to hitting the maximum yearly contributions with its tax advantages, employer match, compounding interest, and other factors. 

However, your retirement savings doesn't have to stop there. You can also consider an IRA, the stock market and even an HSA to extend your retirement nest egg. 

One way to increase your savings rate is by paying off high-interest debt. The Tally† credit card debt repayment app can help with this. The app manages your credit card payments, and Tally offers a lower-interest personal line of credit, allowing you to pay off higher-interest credit cards efficiently. 

†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 to $300.