The 401(k) is one of the best tools you have in your savings arsenal.
It allows you to contribute money directly from your paycheck. Don’t worry if your company doesn’t offer a 401(k), they might offer a different type of retirement account that’s just as good such as a SEP, SIMPLE, 403(b), or 457 account.
Why you should contribute to your 401(k) account:
- Easy to set up. If you are interested in participating in your company’s 401(k) plan, just ask your HR department or talk to your boss. Enrollment only requires completion of a couple of forms. It couldn’t be easier.
- Automatic. Once you have it set up, it runs itself. Every pay period, you will have money automatically taken out of your paycheck and contributed to your 401(k) account.
- Tax savings. Have you ever looked at all of the deductions on your pay stub? Federal income tax, state income tax, state disability, Social Security, Medicare, unemployment, etc. The list goes on and on. How would you like to pay less income tax? Contributing to a 401(k) gives you the chance to do just that. Every dollar you contribute to your 401(k) account escapes all of these taxes because the money is taken out before these taxes are applied!
- Free money. How would you like to benefit from an instant⎯and unsolicited⎯pay raise? Many companies with 401(k) retirement plans match part or all of their employee’s contributions. For example, a company might contribute 25 cents for every dollar an employee contributes. If the employee contributes a dollar every paycheck the company will deposit 25 cents in that employee’s account. The employee gets the extra 25 cents without having to work any harder or negotiate a raise. This can add up to hundreds of thousands of dollars in “free” money for your retirement. For example, under this scenario you’d have over $900,000 of free money if you contribute just $100 a week from your paycheck (assuming 10% return and contributions for 45 years).
- It’s easy. Once you have contributed money to your 401(k) account, it is easy to invest that money. Once you have selected the investments you want to purchase, any additional money can be automatically invested for you.
- Shielded from lawsuits. Any money you have in your 401(k) account is protected from lawsuits and bankruptcies. In a litigious world, this is a huge benefit. It’s hard to find a better or easier retirement savings vehicle than the 401(k), but that doesn’t mean it’s the only retirement savings vehicle or that it is appropriate for non-retirement goals.
Problems with the 401(k)
- Caps on annual contributions. You can only contribute a maximum per year from your paycheck. While this may be more than enough for a lot of people, you may want or need to contribute more annually to your retirement.
- Eventually have to pay tax. The good news is that your contributions to your 401(k) occur before your paycheck is taxed. The bad news is that you can’t escape tax forever. When you withdraw money from your 401(k), you have to pay income tax. What’s the point of contributing? In addition to the many other benefits discussed above, your money has been able to grow tax-deferred all of this time and you don’t have to pay payroll taxes such as Social Security, unemployment, and Medicare. In the end, this “problem” is a good one to have.
- Only good for retirement savings. Money you contribute to your 401(k) should be earmarked for retirement purposes only because if you take money out before you turn 59 ½, you will be hit with a 10% penalty on the amount withdrawn⎯in addition to income tax (there are a few exceptions). As a result of the penalty, a 401(k) is not a good place to save for non-retirement goals such as an emergency fund, new car, or vacation.
If you are saving for your retirement (and you should be!), take full advantage of your company’s 401(k) plan. But how much should you contribute? The short answer is “as much as you can.” The long answer is “it depends.” There are no hard and fast rules, but here are a few tips you can use when you are calculating how much to contribute.
401(k) Contribution Tips
- Retirement savings should be your number one goal after having an emergency fund with three months of cash.
- Contribute at least as much as your company is willing to match. For example, your company may match a certain percentage of what you contribute up to a maximum amount. If your company will contribute 50 cents for every dollar you contribute up to 6% of your salary, you should contribute at least 6% of your salary in order to get as much free money from the company as possible.
- Make sure you save for your non-retirement goals as well. Just because you contribute to your 401(k) doesn’t necessarily mean you shouldn’t be saving in other accounts. Follow the Spending Pyramid and the cash-flow plan you created in the last chapter.
- When in doubt, save more than you think you’ll need.
- If you get a raise, increase your contribution to your 401(k) by the same amount. If you were getting by without the raise, you won’t even notice that it’s going to your 401(k).
- If you get a bonus, ask your HR department if they can deposit the whole amount in your 401(k).
You should definitely take advantage of your company’s retirement account. Unfortunately, this is where most people stop. This is one of the best and easiest ways to save for your retirement, but it is a terrible way to save for your other goals.
The proceeding blog post is an excerpt from The Six-Day Financial Makeover: Transform Your Financial Life in Less Than a Week!, available now on Amazon.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.