How to Make the Most of Your 401(k)

 
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How to Make the Most of Your 401(k)

 

What if I told you there’s an easy and legal way to get more money from your company, actually, free money? You might laugh and tell me there’s no such thing. Money doesn’t grow on trees! But it’s true. Two-thirds of full-time American workers have access to their company’s retirement plans. When you take advantage of this benefit, you can get free money in the form of your company’s matching contribution. Let’s take a more in-depth look.

 

What is a 401(k)?

A 401(k) is a retirement account provided by an employer. It’s funded using an employee’s earnings before taxation. Sometimes it’s also funded at least in part by an employer. Your employer may match your contributions to your 401(k) up to a certain percentage and/or amount. The exact percentage or amount depends on your employer. As long as you make a contribution first, you get this free money from your employer.

A 401(k) has even better benefits than this. There is the tax advantage. Because your 401(k) is funded with your pre-tax earnings, it lowers your amount of current taxable income. You end up paying less in taxes now. You’ll pay taxes when you withdraw the money later in your retirement. It’s likely you’ll have less income in retirement than now, so you’ll again be paying lower taxes.

Another benefit is that the money you sock away has the potential to grow exponentially due to compound interest. The money you contribute at age 30 can grow untaxed for 35 years until you retire and start withdrawing at age 65. You’ll pay taxes only when you withdraw the money.

 

Example

To find out your potential 401(k) balance at retirement with and without an employer match, you can use a calculator like this one from Nerd Wallet.

I entered some numbers to see how much an employer contribution can make a difference. I made up a 30-year-old who makes $50,000 a year. He’ starting with $0 in his account, but his employer matches 50% of his contributions up to 6% of his salary. The difference by age 65 is $1,140,000 to $760,000. That’s $379,000!

This is a hypothetical example, of course. You may change companies during your work years and work for a company that’s more or less generous. You might increase the percentage of your income that you contribute as your salary increases. Nonetheless, you still end up with more in your 401(k) balance when you have your employer’s matching contribution than when you save all on your own. 

 401(k) balance with an employer contribution

401(k) balance with an employer contribution

 401(k) balance without an employer contribution

401(k) balance without an employer contribution

 

How can I make the most of my 401(k)?

1)  Find out what your employer offers.

If you’re not currently enrolled in your company’s 401(k) plan, contact your company’s HR department to see if it is available to you. If it is, ask for all the information you can about it and read through the materials provided. Not all 401(k) plans are created equal. Some companies offer limited investment options within the plan. Options vary in their fees and performance. It’s important to look through the information to make the best decision you can about enrolling in a 401(k).

 

2)  Determine what percentage of your income you want to contribute to your 401(k).

Some employers will automatically enroll you in a 401(k) plan. Typically it’s a small percentage, something like 2% of your pre-tax income. You’ll want to be more proactive than letting yourself default onto a plan. For one, you may have a suboptimal plan that charges high fees and doesn’t perform well. Secondly, if you only put in 2% and your company matches up to 6%, you’re not getting the full benefit of their matching.

Your best move is to determine what percentage your income you want to contribute based on your income and financial goals. A general rule of thumb is to allocate 10% of your pre-tax dollars towards your 401(k). Some people may be growing their emergency fund or saving for a house and decide to do less. Others may want to save and grow their retirement savings aggressively, so they put in more.

 

3)  Consider increasing your contributions over time.

If you can’t contribute enough to maximize your company’s match at this moment, you may find it easier to increase your contributions over time. An easy way to do this is to increase your contribution 1% per year or every time you get a pay raise. You would probably feel an immediate 10% deduction from your paycheck if you contributed 0% to start, but you might not notice much difference between a 5% to 6% deduction.

 

4)  Note contribution limits.

In 2018, individuals under age 50 can contribute up to $18,500. Individuals over age 50 can contribute an additional $6,000 to “catch up” on savings.

 

5)  Determine if your company requires vesting.

In the past, I’ve worked for companies that require you work there for a certain amount of time to keep 100% of their matching contribution. The money that you contribute to your 401(k) is yours, but the matched portion is not, at least not yet. A company may give you 25% of the matching portion when you work there for 2 years. That may increase to 50% after 3 years and 100% after 4 years. The matching portion is not completely yours until you’re fully vested in your company. If you leave before you’re fully vested, you’ll only receive a portion or nothing at all.

 

What if I have debt?

As with most things, the answer is that it depends. Generally, it’s suggested that you contribute enough to maximize your company’s match because it’s one of the easiest ways you’ll ever get a good chunk of free money and you want to take advantage of it while it’s available to you. Once you’ve contributed at least that much, then tackle your debt.

As someone who has been in debt, however, I believe that nothing the beats the peace of mind you have when you’re not in debt. If you’re like me and being in debt feels like an albatross around your neck, then you may want to be more aggressive about paying off your debt while making a small contribution to your 401(k).

 

What if my company doesn’t match contributions or provide a 401(k)?

I mentioned above that two-thirds of full-time American workers have access to a plan such as a 401(k). That means that one-third do not. Other retirement plans are available, such as the IRA and Roth IRA. These are funded with your own money and they don’t come with matching contributions, but they are beneficial vehicles to save for retirement. They are also an additional option to save for retirement if you’ve hit the contribution limit on your 401(k) for the year.

 

A final note

Amongst people in my life, I’ve heard a co-worker say, “I don’t bother with that because I don’t know anything about it.” Another young friend said, “I should cash out my 401(k) because I’m not contributing to it anymore.” There’s a lot of misunderstanding and fear that keeps people from taking part in their 401(k) plan and maximizing their benefits.

What’s a bigger fear: trying out your 401(k) or waking up in retirement one day without enough money to survive? It’s scary to think about that second possibility actually coming true. Don’t let that be you! Give your 401(k) a try today and if you’re already enrolled, try the tips above to maximize its advantages. Most of all, take advantage of free money in the form of your employer’s matching contribution.