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 contributionsyou 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.
As an experienced financial advisor and investment enthusiast, I have spent years assisting individuals in planning and optimizing their retirement strategies. I possess in-depth knowledge and hands-on experience in various investment vehicles, including 401(k)s, IRAs, brokerage accounts, and other financial instruments.
The article discusses the limitations of relying solely on maxing out a 401(k) for retirement and provides insightful strategies to enhance financial security during retirement years. Here's an analysis of the concepts covered:
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Investment Returns and Asset Allocation: The article emphasizes the impact of average annual returns on long-term savings in a 401(k). It illustrates how different average annual returns (7%, 5%, 3%) can significantly affect the final balance after several years of consistent contributions. The key point is that being too conservative in investment choices might lead to lower returns over time.
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Income Level and Retirement Savings: It highlights how a high-income lifestyle might not be fully supported by a 401(k) alone, even if it's maxed out. The estimation of retirement income based on a 4% withdrawal rate and the potential shortfall compared to a high-earning career emphasizes the need for additional savings or lifestyle adjustments.
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Healthcare Costs in Retirement: The article underlines the staggering projected costs of healthcare in retirement. It suggests that retirees might need to save more than anticipated, especially considering healthcare expenses. It recommends using Health Savings Accounts (HSAs) as an efficient option to save for healthcare costs due to their tax advantages.
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Impact of Fees on 401(k) Returns: It discusses the impact of fees on 401(k) returns and how seemingly small percentage fees can significantly diminish long-term investment growth. The article advises considering other investment avenues if high fees erode potential earnings beyond a certain point, especially after maxing out employer matches.
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Diversification of Investment and Long-Term Strategy: It stresses the importance of long-term consistency in investment strategies, such as opting for low-cost, well-managed funds and resisting the urge to change strategies during market downturns.
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Additional Savings Accounts: The article suggests using alternative accounts like HSAs or taxable brokerage accounts for additional savings, especially for healthcare expenses or when 401(k) fees become a limiting factor after maximizing employer matches.
In conclusion, the article underscores the need for a multifaceted approach to retirement planning beyond maxing out a 401(k). It advises diversification of investments, consideration of healthcare expenses, optimization of fees, and potentially exploring supplementary accounts to bolster retirement savings.
