401(k) plans are employer-sponsored savings plans that provide employees with valuable tax breaks for investing a portion of their paycheck to save for retirement. Employers offering these plans can choose to make matching or non-elective contributions to the plan on behalf of their eligible employees and may even incorporate a profit-sharing feature into the plan.
Overview: 401(k) Plans
The 401(k), named after the subsection of the IRS code that governs it, became law in 1978. Prior to this, most employers offered pension plans to employees. Employers were responsible for managing these plans, which would later provide employees a steady stream of income over the course of their retirement. However, as the cost of offering pensions increased, employers began to turn to 401(k) plans as a more cost-effective alternative.
Initially, these plans also had their downsides, with plan fees and limited investment options as two of the most common complaints. However, recent 401(k) plan reform has made a wide range of improvements to benefit employees. The average plan now offers over two dozen different investment options, and plan costs continue to drop year-over-year. New features such as automatic enrollment, increased fee visibility, and catch-up contributions are only improving the user experience.
The other key differentiator of a 401(k) plan is the employee’s control over their investments. Whereas it is the employer’s responsibility to manage pensions, 401(k)s offer employees a whole spread of options to choose from. These typically include a variety of mutual funds composed of stocks, bonds, and money market investments. Usually, employees opt for target-date funds which gradually become more conservative as the employee’s target retirement date approaches. However, ultimately the employee has complete control over where their investments go.
Traditional vs. Roth
One of the greatest advantages of 401(k) plans is the tax-advantaged nature of earnings. The Traditional 401(k) allows employees to make pre-tax contributions and lets the funds grow untaxed. Taxes are only collected later on when withdrawals are made from the account. An added bonus is that pre-tax contributions to a Traditional 401(k) also lower your total taxable income for the year. For example, if you make $70,000 a year and put $15,000 into your 401(k), you will only have to pay income taxes on the $55,000 rather than the whole $70,000!
In 2006, the IRS released the Roth 401(k) option. The opposite of the Traditional 401(k), the Roth option gets taxes out of the way right off the bat. Roth contributions are made with after-tax dollars, so the money will be free from taxes when you start taking distributions! While still not as common as Traditional plans, Roth 401(k)s are growing in popularity and are now offered in over half of company 401(k) plans.
How much should I invest?
So now you have a pretty solid understanding of 401(k) plans and how they work… But how do you choose how much to actually invest? With only a small fraction of plans listing recommended contribution amounts and most advice simply saying, “invest as much as possible,” it’s easy to feel at a loss. A few guidelines to determine your investment are:
- Invest enough to get the full matching amount from your company (or as much as you can afford). Almost every plan offers matching (usually up to 3% of your salary). Check with your employer to make sure you’re taking advantage of as much of this free money as possible!
- Aim to save more than 10%, with a good goal being 15%. Under the 50/20/30 Guideline, 20% of your earnings should go towards your financial goals. These include emergency savings, retirement, paying off debt, and other future goals. By contributing 10-15% to your 401(k), you will still have another 5-10% to put towards other goals like buying a house or saving for that backpacking trip through Europe you’ve always wanted to take!
- Factor in your age. If this is your first job and you’re 22, a smaller contribution still has a lot of time to compound and grow to a sizeable amount by the time you hit retirement. However, if you’re already in your 40’s, you will need to save much more to achieve the same result by the time you retire.
- That being said… Increase your savings rate over time! Back to our earlier example, if you’re just starting out and can’t afford a 10-15% contribution, opt to put in as much as you can for now. Once you get a raise or promotion, up your contribution as well. It is wise to revisit your contributions (and savings in general!) after each raise or salary increase. Some plans now even have automatic escalation features you can use to boost your savings rate over time.
- Maximize your contributions. If you’re super savings-savvy, you may actually hit the maximum contribution limit for your 401(k)! For 2018, this limit is $18,500. However, employees aged 50 and above can make “catch-up” contributions of up to an additional $6,000, putting their maximum contribution at $24,500.
What do you think?
Ready to start saving? Contact your employer today to make sure you’re making the most of your 401(k) plan. If you’re an employer, are you currently offering this benefit to your employees? And if so, when was the last time you revisited your plan? Contact us today to learn about our customized, qualified Retirement Plans. We’ll work with you to maximize your employees’ investments, bring you the greatest tax benefit, and save you time and money by integrating with payroll!
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