Should You Max Out Your 401(k)?

Let’s start with a more basic question: Can you max out your 401(k)?

The answer is: not likely. According to 2010 data from the Center for Retirement Research at Boston College, 6.7% of 401(k) participants contributed the maximum (then $16,500, now $17,500) to their 401(k) or similar retirement plans.

For the personal finance coach whose mantra is “max out that 401(k),” this seems dire, but a closer look at the data presents a more nuanced picture:

• 72% of people who participate in a 401(k) contribute enough to get the full employer match
• The vast majority of people over 30 who have access to a 401(k) use it. This is true even for the majority of low-income workers.
• Among workers making over $100,000 per year, 28% maxed out their 401(k).

The tax benefit of the 401 is awesome, and the higher your tax bracket, the more of a steal it is. Most people with the means to max out their 401(k) will save on taxes by doing so.

Everyone (including workers themselves, judging by the data) agrees that getting the full employer match is the personal finance equivalent of brushing your teeth. Let’s take a typical (but not very generous) match example.

Say an employer matches 100% of the first 3% of salary contributed to the plan. On a $100,000 salary, that’s $3,000. The employer also contributes $3,000, but that contribution doesn’t count toward the annual limit, so the employee still has $14,500 of room in the 401(k).

Whether you’re in a position to max out your 401(k) or not, once you get the match, you have to decide what to do with your next $100 of savings, and the one after that, and (if you’re lucky) the one after that. Continuing to fill up that 401(k) is often a good idea, but here are a few other possibilities to consider first.

Bulk up your emergency fund

A cash emergency fund is the financial equivalent of a cast for a broken arm: it patches over a tough spot and prevents the problem from getting worse.

According to the 2013 Assets & Opportunity Scorecard from the Corporation for Enterprise Development, 44% of Americans don’t have enough cash savings to last them three months.

If you’re in this category, this should be your top priority, unless…

Knock off debt

Paying off a credit card charging 16% interest is the equivalent of earning 16% interest on an investment, risk-free. No investment can offer that.

So definitely pay off credit cards before investing beyond the 401(k) match. I don’t think that’s a controversial statement.

Also consider paying down student loans, car loans, and, yes, even your mortgage.

Invest in your business or career

Workers in their 20s are the least likely to contribute to a 401(k). Why? Because they don’t make much money and they’re figuring out what they want to do with their lives.

That means unpaid internships, continuing education, entrepreneurship, and lots of other stuff that makes negative profit at first, but has the potential for a career’s worth of extra income.

Choosing the right kind of personal growth or career makeover is hard, and I suspect that many people overpay.

Michael Kitces of the Nerd’s Eye View blog wrote about how young workers can and should deploy their savings for career advancement in a post provocatively titled Why Saving In A Roth (Or Any) IRA Might Be A Bad Idea For Young People After All.

That said, consider a Roth or traditional IRA

Unless you work for a large company or government, you can probably get cheaper and more diversified investments in an IRA than in your 401(k), and the tax advantage is the same.

In general, for retirement savings, I think it makes sense to stick with the 401(k) after the match, unless your 401(k) is extremely bad.

Setting up an IRA isn’t difficult, by any means, but the convenience of the 401(k) means you’re more likely to actually use it, and you’ll roll it over into an IRA when you change jobs anyway.

How do you know if your 401(k) is really bad? Check the fee disclosure.

And here are a couple of bad ideas:

Bad idea: Any kind of taxable investment

It’s silly to invest in a taxable account when you get such a big tax break for using your 401(k). If you max out the 401(k) and are still able to invest more, by all means use a taxable account.

Bad idea: Weird, incomprehensible, or insurance-based investments

Do I even need to explain? Maybe so.

Let’s talk about our military service members for a moment. Military personnel receive a steady paycheck and have access to the nation’s best 401(k) (the Federal Government’s Thrift Savings Plan).

Naturally, a “financial advising” industry has sprung up around military bases, and the pitch goes like this: “The TSP is too risky/bankrupt/otherwise lousy. Invest with me instead. I promise to protect your money and get you better returns. And I won’t charge you a dime.”

Then the salesgoon pushes complex investments, such as variable annuities, that pay big commissions to the “advisor,” take more money out of the soldier’s pocket, and take longer to untangle yourself from than a land war in Asia.

Members of the military aren’t the only people at risk of this kind of scam (which is, amazingly, generally legal). Doctors, retirees, teachers, technology workers: all draw the same kind of sleazy pitch.

Something tells me there’s not a lot of overlap between people who fall for investment scams and people who read financial columns, but, hey, just in case: Nobody is actually going to give you personalized financial planning for free. You’ll pay and pay and never see the price tag, just a vastly diminished account balance over time.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.