Whether you’ve just started your first job offering a 401(k) retirement plan, or already have one, you may be faced with questions about how it can best serve your retirement needs. Should you contribute to a 401(k)? How much should you contribute? How should you invest your account’s funds?
Keep reading to learn more about the 401(k) basics and how it can help you.
What Is A 401(k)?
A 401(k) is an employer-sponsored retirement account. You contribute pre-tax dollars, taken out of your paycheck, to the account and your money grows tax-deferred. You’ll choose a set amount to deposit in your 401(k) and your employer will automatically deduct that amount from your paycheck, depositing it in your 401(k) for you, where you can decide how you want to invest it.
1. Contributing Will Lower Your Tax Bill
As we stated above, you contribute pre-tax dollars to your 401(k). This will directly reduce your tax liability. Even if you take $100 out of your paycheck to deposit in your 401(k), you reduce your taxable income every pay period by $100. Over 12 months, that’s $1,200 that you get to keep, which won’t have any taxes taken out of it this year.
Now the true benefit occurs while your money grows. Your earnings grow tax-deferred too. In other words, you don’t pay taxes on any of the money until you withdraw it during retirement. For many people, this means paying even less taxes on the money because most people end up in a lower tax bracket during retirement.
2. How Much Can You Contribute Depends On Your Age
In 2020, employees can contribute up to $19,500 to their 401(k). This means you can defer paying taxes on up to $19,500 of your income for the year. As you age, you may be able to contribute an additional amount of catch-up contributions (for 2020 the catch-up contribution maximum is $6,000).
3. Take Advantage of Employer Matches
The tax benefits of the 401(k) are great, but there’s another benefit you may be able to enjoy – the employer match. Many employers match your contributions up to a certain extent. For example, let’s say that your company will match your contributions up to 3% of your salary. If you make $50,000 per year, that means your employer will contribute up to $1,500 to your 401(k) account, as long as you contribute at least that much – which is similar to getting a $1,500 raise!
This is why it’s so important to contribute to your 401(k). Let’s say you didn’t contribute $1,500 to your 401(k) this year. That means you are now $3,000 behind on your retirement savings, not to mention the return you may have earned on the investments. Every year that you don’t contribute, you let more money fly out the window. Let’s say you didn’t contribute to your 401(k) for the first five years. You just let $7,500 in ‘free’ money,’ leave you, not to mention the $7,500 you would have invested in yourself during that time.
Even if money is tight, at the very least, contribute as much as your employer will match. If you can’t afford any more than that, you can increase your contributions in the future. It’s important to start somewhere, though. This is the first rule of 401(k) basics.
4. Set Reminders for Annual Increases
Try setting a rule to increase your 401(k) contributions every year. If your HR department offers an automatic increase, set it up so that you don’t have to worry about it. If not, set a reminder on your calendar for the same time every year to increase your contributions.
Even if you only increase your contributions by 1%, you increase how much you’ll have in your retirement account quicker than you think. Let’s say for example that you make $50,000 and currently contribute 3%, that’s $1,500. Next year you increase it to 4%, which means $2,000 and the next year you contribute 5%, which means $2,500. Every year that money grows tax-deferred, plus you have the employer match if you haven’t maxed it out yet.
It’s also a great idea to increase your contributions every time you get a raise. Even if it’s a 3% raise, increasing your 401(k) contributions 1% - 2% will have a major effect on your retirement savings 35 years from now.
5. Don’t React To Market Fluctuations
It can be stressful watching the market fluctuate, but don’t let it impact your retirement saving strategy. The market is going to go up and down throughout your career. You will see major losses and major gains. Your retirement savings are in it for the long haul. While you are young, it’s okay to be aggressive with your investments. It’s even okay if the market drops. You have the benefit of time and over time, properly diversified investments will appreciate in value.
Of course, one of the best ways to mitigate risk is to diversify your portfolio. In other words, don’t put all your eggs in one basket. Choose a variety of aggressive and conservative investments. This way you don’t lose it all when one investment takes a dive. In the end, it all balances itself out. Most investments your plan’s 401(k) offers are already diversified, but it’s wise to diversify further by investing your money in more than one fund.
6. What Happens if you Change Jobs
The money you invest in your 401(k) travels with you as you change jobs. You can roll it over into your 401(k) at your new employer or open your own IRA. You won’t pay penalties or taxes to do this. However, your matched employer contributions may be subject to a vesting schedule, and if they are not fully vested, they may or may not be transferable. Know the vesting period your employer requires in order for you to take some or all of your matching contributions with you. Try sticking it out at least as long as necessary to be fully vested. This means the employer contributions are yours and you are free to take them with you.
7. Your Investment Strategy Should Change As You Age
Before you choose your investments, take a deep breath and tell yourself you are okay with risk. In your 20s and even 30s, you have plenty of time ahead of you to recoup any loses. Wouldn’t you rather take a risk and earn some major gains? Now is the time to start.
So how should you allocate your investments? Asset allocation diversifies your risk. You want some money invested in stocks, some in bonds, and some in target funds. A general rule of thumb is to take your current age and subtract it from 100. That’s the percentage you should invest in stocks. So if you are 25-years old, invest 75% of your assets in stocks and spread the other 25% amongst stocks and target funds.
Of course, if you can’t stomach the thought of exposing 75% of your money to riskier investments, you may want to adjust it. As you grow older, you’ll want to slowly pull back on your aggressiveness too by reducing the percent of your portfolio that is invested in stocks. Every year that you get closer to retirement is another year to get just a little more conservative in your investments. As you get real close to retirement, the majority of your investments should be conservatively invested to reduce the risk of landing in retirement with nothing.
As you choose your asset allocation, try spreading out the risk. For example, in the stock category, consider investing in US large cap, US small cap, and real estate. In other words, don’t put it all in US large cap or US small cap, spread out the wealth and the risk.
8. Don’t Forget to Pay your Debts
Saving for retirement is important, but so is staying out of debt. Don’t let yourself get swayed too far one way or the other. Don’t put all of your free money into your 401(k) and ignore your student loans and credit card debt. But also don’t focus all of your money on paying down your debts and forgetting to save for retirement. It’s a fine balance that you have to figure out so that you have enough retirement savings, but are also able to go into retirement debt free.