Should I max out my 401(k)?

A maxed out 401(k) is one more step you can take that may help you get closer to your retirement goals. If a workplace 401(k) is the centerpiece of your retirement savings plan, it's important to know how to make the most of your contribution.

Maxing out your 401(k) simply means making contributions up to the annual limit set by the IRS. For 2021, the maximum amount you can contribute to a 401(k) is $19,500. You can add another $6,500 in catch-up contributions if you're age 50 or older.

These limits only apply to your contributions. If your employer offers a matching contribution, different limits exist for how much an employer can add on your behalf. For 2021, the combined employee-employer contribution limit is $58,000 or $64,500 when you add in catch-up contributions.

You have one very simple reason to max out your 401(k): The more you contribute, the bigger your retirement savings may be.

Say you have two employees at the same company, both aged 25 and making $50,000 each year. Employee A contributes 10% or $5,000 of their pay to their 401(k) annually. Employee B contributes 39% of their pay, or $19,500. Both get the same employer 100% match, up to the first 6% of their salary.

Both employees invest in their plans for 40 years, earning an annual return of 7% each year. In this example, at age 65, Employee A retires with $1.66 million. That's significant retirement savings. But Employee B, who maxed out their plan each year, ends up with significantly more: $4.39 million.

This is a hypothetical example, of course. And it doesn't account for the added value of catch-up contributions. But it shows how much more you could end up with for retirement if you contribute the full amount to your 401(k) every year.

While it’s a great savings strategy, maxing out a 401(k) is not a realistic goal for everyone. If you're making $50,000 a year, then contributing the maximum would leave you with $30,500 to live on. That could be challenging, especially if you live in a more expensive city, have debt you're paying off or are saving for multiple goals.

On the other hand, maxing out a 401(k) may be less of a stretch for higher earners. Someone who's making $130,000 a year, for example, can accomplish this savings goal by contributing 15% of their income.

Additionally, if you’re limited in how much you save for retirement, a maxed out 401(k) could prevent you from taking advantage of other retirement investing choices, like individual retirement accounts (IRAs). Contributing to a Traditional IRA, for instance, could yield a tax break in the form of a deduction. A Roth IRA, on the other hand, allows for tax-free withdrawals in retirement. With a regular taxable brokerage account (and not an IRA), you're not bound by annual contribution limits.

Quick tip: If you can’t immediately contribute the maximum amount to your 401(k), you might also consider increasing your contributions by 1% each year until you reach the annual limit.

Retirement may be well off in the future, but you are probably already doing several things to prepare for it. While everyone’s retirement to-do list is different, it’s worth it to consider adding “max out your 401(k)” to yours.