While many employees contribute to a 401(k) retirement plan through their workplace, others use a 403(b) or a 457 plan instead, though they work very similarly. Here are seven essential best practices to make sure you get the most out of participation in a retirement plan at work.
Save as Much as Possible Today
It is often wise to go beyond the default savings rates that many plans automatically use to enroll new hires. Most financial planners agree that you need to save 10% to 20% of your total earned income each year throughout the course of your working career to maintain the same lifestyle during retirement. This approach increases the likelihood that you will accumulate enough savings to meet income goals during retirement. The Internal Revenue Service (IRS) updates its contribution limits each year for 401(k)s. In 2022, you can contribute up to $20,500 to a 401(k), and if you are 50 or older, you can contribute another $6,500 as a catch-up contribution. In 2023, you can contribute up to $22,500 to a 401(k) and another $7,500 in catch-up contributions if you are 50 or older.
Max the Match
If your employer offers a matching program for your contributions, be sure to take full advantage of this free money that can provide a boost to your retirement savings. For example, your employer might offer a 5% match, meaning they’ll contribute 5% of your salary as long as you also contribute 5%. The percentages can vary depending on the plan, but for you to qualify for the match, you must contribute as well.
Think About Your Current Tax Rate and Future Taxes
Pre-tax contributions to 401(k) plans provide an immediate tax benefit. In other words, your contributions reduce your taxable income before income taxes have been deducted from your paycheck. You can estimate the amount of tax savings you will see as a result of pre-tax contributions by using tools like this pre-tax savings calculator. Also, your money is invested over the years and grows on a tax-deferred basis. Typically, in a taxable account, the interest earned or capital gains would be taxed each year. With a 401(k), you’re not taxed on your contributions or investment earnings until you take out distributions in retirement. Some retirement plans offer a Roth option. Roth 401(k)s use after-tax contributions, meaning there’s no upfront tax benefit, but your investment earnings grow tax-free and qualified withdrawals in retirement are tax-free. A Roth 401(k) is usually a smart choice if you do not need the current tax benefits of pre-tax contributions or anticipate being in the same or higher tax bracket when you begin taking distributions.
Make Your Savings Automatic
By having your salary deferrals on automatic, the money will be deducted from your paycheck and invested each pay period. Automating your savings can help you budget for your retirement. Also, with a fixed percentage of your salary being allocated to your 401(k), as your salary increases over the years, you will contribute more money. However, since your money is earning interest or capital gains and you’re reinvesting those gains, you benefit from the power of compounding. Compounding is when you earn interest on your interest, which helps magnify the growth of your savings. Let’s look at an example of how automatic salary deferrals with an employer match can help you build your retirement nest egg.
Automatic Saving
Michelle is 30 years old and is contributing 6% of her $65,000 salary to her 401(k) plan for 35 years. Here’s the breakdown of how much Michelle is saving in 35 years.
$325 per month$3,900 annually ($65,000 * 0.06)After 35 years = $136,500 in total employee contributions
After Employer Match
Let’s say that Michelle’s employer matches 50% of her first 6% contributed. As long as Michelle contributes 6% per year, she’ll get an additional 3% added in free money from her employer.
$162.50 per month$1,950 annually ($65,000 * 0.03)After 35 years = $68,250 in total employer matching contributions
The Power of Compounding
Below is a calculation of how Michelle’s retirement grows with the power of compounding using both her contributions and the employer match.
Monthly contribution: $487.50 ($325 from Michelle and $162.50 from her employer)The annual rate of return from investments: 8%After 35 years = $1.095 million in total
The interest was reinvested or compounded on a quarterly basis. We can see that Michelle would have a total of $204,750 saved in 35 years from her contributions and the employer match ($136,500 + $68,250). However, compounding or reinvesting the investment gains grows her 401(k) to over $1 million. In reality, Michelle might change jobs over the years, and her salary might change or increase. Nonetheless, the example shows that setting your 401(k) contributions on automatic and taking advantage of an employer match can help you build wealth in the long run by maximizing the benefits of a 401(k).
Choose the Right Investment Mix for Your Situation
For many retirement investors, portfolio selection can be a challenge. Finding an appropriate asset allocation model requires matching your comfort level with risk as an investor with your investing time horizon. Many retirement plans now offer static asset allocation funds or target date funds to help plan participants diversify their investments across multiple asset classes (i.e., stocks, bonds/fixed income, real estate, alternative investments).
Avoid Early Withdrawals
It may be tempting to take an early withdrawal, but the long-term consequences are often not worthwhile. 401(k) withdrawal rules can be complicated, though there are certain situations where penalties can be avoided. However, if you leave an employer or encounter financial hardships, it is often recommended to avoid early withdrawals from a 401(k) plan.
Only Use 401(k) Loans as a Last Resort
Some positive 401(k) loan features include no credit checks and competitive interest rates. They can be a potential source of funds, but it is often wise to avoid borrowing against your 401(k). There is an opportunity cost, though: You may miss out on market gains while you are paying interest to yourself. The biggest risk is that you could end up owing taxes and penalties if you leave your job and cannot repay the outstanding loan balance. To avoid paying the taxes and penalties associated with early distribution, you would need to roll the outstanding loan balance over to an IRA or other eligible retirement plan by the due date (including any extensions) for filing your federal income tax return.
Next Steps: Create an Action Plan for Retirement
In order to get the most out of your 401(k) plan, it is important to have a clear vision of why you are saving for retirement in the first place. We all have our own unique definition of what the word “retirement” actually means. If you want to make sure you are making the smartest choices with your 401(k), take some time to assess your goals and review how many of the seven steps mentioned above you have already taken. Please consult a financial advisor or retirement planning expert to help you develop a strategy to achieve your financial goals. Conversely, a Roth provides tax-free earnings growth and withdrawals in retirement but has no upfront tax benefit. Also, avoid early withdrawals to prevent a penalty by the IRS.
