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The Unfortunate Truth About Maxing Out Your 401(k)

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The Unfortunate Truth About Maxing Out Your 401(k)

If your entire retirement plan is built on maxing out your 401(k), I have some bad news: Contributing the annual maximum to your 401(k) doesn't guarantee a comfortable retirement.

Read on to learn four reasons why maxing out your 401(k) may not be enough, and what you can do about it.

1. You're not invested aggressively enough

As you can see in the table below, your average annual returns greatly affect your long-term results.

Monthly Contribution

Average Annual Return

Balance After 35 Years

$1,708

7%

$2,851,538

$1,708

5%

$1,860,626

$1,708

3%

$1,244,036

Data source: Author calculations via Investor.gov.

The $1,708 contribution is the rounded-down monthly equivalent of the 2022 contribution cap for savers under 50 years old, which is $20,500.

Take a look at the difference between the ending balance at 3% vs. the ending balance at 7% -- it's about $1.6 million. That's not all free money, of course. To realize a 7% return, you must take on added risk by investing mostly in stock funds versus bond funds.

Fortunately, you can mitigate much of the risk by investing regularly over the long term. For your stocks, choose large-cap funds with low expense ratios and keep investing, no matter what. Resist the urge to change your strategy in market downturns.

That consistency -- over decades -- allows you to capitalize on lower share prices and prevents you from realizing unnecessary losses. The result is a higher profit potential over time.

Image source: Getty Images.

2. You have a high-income lifestyle

Say you do max out your 401(k) for 35 years, earning 7% annually along the way. Your $2.85 million balance at retirement will support annual income of about $114,000. That's assuming your withdrawal rate is 4% annually.

You should earn Social Security on top of that. If you've earned a high salary your whole career, you might qualify for the maximum benefit at full retirement age of $40,140.

Together, those two income sources total about $154,140 annually. If your working income today is well above that number, your savings might feel insufficient.

You have two options. First, you can trim your lifestyle now. That benefits you two ways: You'll increase your ability to save for retirement and you'll lower your retirement income needs. Or, you can invest additional funds in another account outside your 401(k). Try an health savings account (HSA) if you're eligible or a taxable brokerage account.

3. You might spend more than expected on healthcare in retirement

Recent estimates on the cost of healthcare in retirement are terrifying. A study from benefits firm Milliman projects cumulative healthcare costs of $295,000 to $564,000 for healthy couples retiring in 2022. The lower end of the range represents those who choose a Medicare Advantage Plus Part D Plan. The higher estimate is for retirees with original Medicare, Medigap, and a Part D plan.

The takeaway is: Whatever savings you think you need to retire, add at least $300,000 to cover your healthcare.

An HSA is an efficient option for healthcare savings. You qualify for an HSA if you have a high-deductible health plan. If you're not sure whether you have such a plan, check with your benefits manager.

You can contribute up to $3,650 pre-tax to an HSA in 2022 if you have self-only coverage. The cap is $7,300 if you have family coverage. Any HSA employer match contributions you earn do count toward those caps.

Invest your HSA so the balance grows along with your 401(k). Any HSA distributions for eligible medical costs are tax-free.

4. 401(k) fees are diluting your results

401(k)s have fees, usually periodic administrative fees and investment fees. Cumulatively, those fees average 0.37% to 1.42% annually. They do reduce your investment returns. The percentages may look small, but the impact adds up over time.

Say your 401(k) charges you a very high 2% annually. If your underlying investments are growing at 7%, your returns, net of fees, will be 5%. As you saw in the table above, lowering your return by 2 percentage points can ultimately cost you $1 million.

If the plan has employer matching contributions, those along with 401(k) tax perks can offset your fees. But once you max out your employer match, it can make sense to save extra funds outside of your 401(k).

A taxable brokerage account can be efficient under two conditions. Invest in tax-efficient securities, like non-dividend-paying stocks. And don't take profits unless you have to. Let your positions appreciate long-term.

You're still likely ahead of the pack

If you're in the running to max out your 401(k), congratulations! You're well ahead of the average retirement saver.

As a next step, make sure those high contributions are delivering the right results. That may require optimizing your investment strategy, trimming the fat from your lifestyle, or investing in an HSA or taxable brokerage account. Make those moves and you'll have a bright retirement future ahead.

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