Should You Max Out Your 401(k)?

A company 401(k) is one of the most popular retirement investment tools available. The plan allows a maximum investment of $16,500 per year (for 2010) and $22,000 for those over 50 years old. As with all other retirement investment platforms, there are both reasons to max out your 401(k) each year and some cautions about doing so.

Maxing Out Your 401(k) -- Pros:

1. Potential company match -- Many corporate 401(k) plans have a provision that provides for company matching of contributions, usually up to a certain percentage of income. This is "free money" and an overall benefit to the investor. It is worthwhile to at least contribute enough to get the maximum matching benefit, even if you do not max out contributions.

2. Tax deferral on contributions -- In a 401(k), you receive a taxable income deduction for your contributions up to the maximum allowed contribution. This reduces your taxes payable in the current year. The flip side of this rule is that withdrawals are taxable in the year withdrawn, which results in a tax deferral for contributions. However, if you expect to be in a lower tax bracket when you retire than you are right now, this is a permanent erasure of taxes. You will benefit by the difference between this year's tax bracket and that in the withdrawal year times the amount of the contribution.

3. Income accumulates on a tax-deferred basis -- The interest, dividends and capital gains earned in a 401(k) grow inside of it tax-deferred. That means that you will pay no tax on the earnings until you withdraw them. That gives you more income to re-invest annually and results in a larger investment account than would be possible if a portion of each year's income went to taxes.

Maxing Out Your 401(k) -- Cons:

1. Potential for an overall increase in taxes -- In situations where you will have a larger taxable income in retirement than you do right now and, therefore, may be in a higher tax bracket then, you may be increasing your overall taxes by investing in a 401(k). Although you are deferring (or "putting off") the taxes on contributions until you retire, you will pay more tax on them than you saved when you made the contributions. This is often the case for younger contributors who are not yet at their maximum earnings potential.

2. May be better off paying down debt -- Your overall wealth profile is an important consideration in whether you should max out your 401(k) or use the money for paying down debt. If you have a lot of current debt, such as mortgages, personal loans or credit card balances, it may be financially advantageous to you to pay down those balances now rather than to carry them and invest for the long term.

3. Limited investment choices -- 401(k)s offered by employers have a limited portfolio of investments from which to choose. Most of these investments will consist of mutual funds and exchange-traded funds (ETFs). Some of these investments will have high expenses and fees and will therefore generate a smaller investment return than other retirement investment choices.