Ask Bob: Is Maxing Out Your 401k A Good Investment Decision?

Published on July 20, 2022

by
Bob Williams
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Since the beginning of 401(k) plans in 1978, people have considered it to be the quintessential retirement plan—you get to save money before taxes and in most cases, the company puts money into your account, too. What could be better than that? But now, 44 years later, it’s time to take a broader look at 401(k)s that considers taxes on 401(k) distributions.

401(k)s certainly have a place in your investment plan. Most employers offer some kind of match up to a certain level. It just makes sense to contribute enough of your money to receive everything the company is willing to contribute on your behalf. It’s free money. To quote an age-old axiom, don’t leave money on the table.

But once you’ve contributed enough to get the entire company match, does it make sense to max-out your 401(k) contributions, which in 2022 is $20,500, or if you are 50 or above, $27,000.

It’s estimated that in retirement you’ll need approximately 80% of your pre-retirement income because:

You won’t be paying in to Social Security
You won’t be saving for retirement
Your mortgage may be paid off
Your kids won’t be financially dependent on you (hopefully)
You may downsize or move to a location with a lower cost of living.

Without all those expenses, lower income may put you in a lower tax bracket. But withdrawals from 401(k) plans are fully taxable as ordinary income. So, if most of your retirement income comes from 401(k) distributions, most of your retirement income will be taxable as ordinary income.

2022 Tax Brackets for Single Filers, Married Couples Filing Jointly

Tax Rate	For Single Filers	For Married Filing Jointly	For Heads of Households
10%	$0 to $10,275	$0 to $20,550	$0 to $14,650
12%	$10,275 to $41,775	$20,550 to $83,550	$14,650 to $55,900
22%	$41,775 to $89,075	$83,550 to $178,150	$55,900 to $89,050
24%	$89,075 to $170,050	$178,150 to $340,100	$89,050 to $170,050
32%	$170,050 to $215,950	$340,100 to $431,900	$170,050 to $215,950
35%	$215,950 to $539,900	$431,900 to $647,850	$215,950 to $539,900
37%	$539,900 or more	$647,850 or more	$539,900 or more
Source: Internal Revenue Service

But what would happen if you contributed enough to your 401(k) to get the company match, and invested the rest into a taxable account? Yes, you’d pay taxes on that money now. But as you liquidate the taxable investments during retirement, you’d be paying capital gains taxes rather than ordinary income taxes.

2022 Tax Rates for Long-Term Capital Gains
Filing Status	0%	15%	20%
Single	Up to $41,675	$41,675 to $459,750	Over $459,750
Head of household	Up to $55,800	$55,800 to $488,500	Over $488,500
Married filing jointly and surviving spouse	Up to $83,350	$83,350 to $517,200	Over $517,200
Married filing separately	Up to $41,675	$41,675 to $258,600	Over $258,600

Source: Internal Revenue Service

You can see from the income tax chart that in 2022, if you are married filing jointly and your income is between $83,550 and $178,150 your marginal ordinary income tax rate is 22%. But the long-term capital gains rate for someone in that same income range is 15%. That’s a substantial difference.

For people making higher incomes, the difference is even more dramatic. If you’re married filing jointly with income between $340,100 and $431,900, the marginal ordinary income tax bracket is 32%, while the long-term capital gains rate is 15%.

Next, what would happen if you took retirement money above the amount needed to get the company match and invested it in a Roth IRA? Just like putting money into a taxable account, you’ll pay income taxes on those contributions, which in 2022 can be $6,000 or $7,000 for people 50 and above. You can withdraw your contributions, tax-free, at any time, and once you reach the age of 59 ½, all the earnings from your contributions can be withdrawn tax-free.

What if you took retirement money above the amount needed to get the company match and invested it in municipal bonds? Just like the previous examples, you’ll pay income taxes on the amount you put into the bonds, but the interest is free from federal taxes, and if the municipal bond is issued by a government entity in the state where you live, you may not have to pay state income taxes on the interest.

Other considerations about whether to put additional money into a 401(k) include:

High 401(k) investment fees. A recent survey by TD Ameritrade found:
- 37% of people don’t believe they pay any 401(k) fees
- 22% didn’t know about fees
- 14% don’t understand how to determine what fees they pay
Fewer investment options than available in personal investment accounts. 401(k) plans generally have 20-25 mutual funds to choose from. About half of them are target-date funds. And there are seldom any commodity or real estate options, which are necessary for true balance in a portfolio.
Not receiving all the employer contributions if you leave the company before you are fully vested.
Can’t access your money without penalty until you’re 59 ½.
Paying income tax on Required Minimum Distributions, which begin at age 72.

Other reasons not to max out your 401(k) that are not tax-related:

Do you have any high-interest credit card debt? If so, pay it off.
Have you built an emergency fund with three to six months of living expenses?
Do you have adequate health insurance?
If you’re married or have children, do you have adequate life insurance?
Do you have adequate disability insurance in case you’re out of work for six months or more because of an injury or ailment?
If you’re close to retirement age, do you have long-term care insurance?

Recap

When you’re working, the bulk of your income is from your job and is fully taxable (after deductions and exemptions) at ordinary income tax rates. When you’re retired, you pay ordinary income taxes on:

Pensions
Annuities
Withdrawals from taxable retirement accounts, which include Required Minimum Distributions
Earned income from continued employment
A maximum of 85% of your Social Security

If you have investment income, you pay taxes on: