But there are times when your money would be better spent elsewhere. What you should do depends on your 401(k) and your financial situation.
When Does It Make Sense to Contribute to a 401(k)?
401(k) plans are meant to help employees and the self-employed save for retirement. The assumption is that your financial needs have been met if you’re saving for retirement. As such, you should only contribute to your 401(k) plan if:
You have an emergency fund: This might be a savings account or another deposit account. Having an emergency fund with enough money to cover three to six months’ worth of expenses can help you avoid having to take money out of your 401(k). If you do that with a traditional 401(k), it can increase your tax bill, and you also may incur an early withdrawal penalty of 10% if you are not yet 59 1/2 years old. You have enough insurance coverage in place: This includes health insurance, property and casualty insurance, and can include life insurance. You have a plan for paying down debt: If you have debt with high interest rates, you may want to pay it down before putting money towards retirement. Try to pay off debt and save for retirement at the same time if possible.
Your 401(k) contributions are for retirement. That means that money can’t typically be used for emergencies, a new car, or anything else. If you don’t have the short-term reserves to pay for these expenses, you could put your money into more liquid deposit accounts. That way, you can readily withdraw from them when the need arises. As a non-liquid account, a 401(k) is not an appealing savings vehicle if you need the money earlier than retirement. If you lose your job, change jobs, or have a health problem arise, you may not be able to access your 401(k) money when you need it. Even if you can, the taxes and penalties may be hefty.
How Do You Decide on a 401(k) Contribution Amount?
Review your financial situation, your company match, and your contribution limits when determining how much of your salary to contribute.
401(k) Contribution Limits
Be sure to stay within the legal limits on 401(k) contributions. Under IRS guidelines, employees can contribute a maximum of $19,500 to a 401(k) plan in 2021. In 2022, this increases to a limit of $20,500. In 2023, this increases to a limit of $22,500. If you’re 50 or older, you can put in an additional $6,500 in “catch-up” contributions in 2022, or an additional $7,500 in 2023. That could give you a total of $27,000 in 2022 or $30,000 in 2023. These limits apply to employee contributions for both employer-sponsored and self-employed 401(k) plans. But if you have a self-employed plan, you can also contribute up to 25% of your net self-employment earnings.
Company Match
If you work for a company, find out if it provides any form of matching contributions to your 401(k) plan. Depending on the match formula, your employer will partially or fully match your contributions to the plan up to a certain amount. For instance, let’s say that your employer offers a 100% match of your contributions for up to 5% of your salary. If you contribute 5% of your income to your 401(k) plan, the firm might match these contributions $1 for $1. This provides you an instant 100% return on any 401(k) contributions you make, up to 5% of your income. This is like free money that will continue to grow in your account until you take it out in retirement. Matching contributions to your account are often subject to a 401(k) vesting schedule. This schedule is a timeline that dictates how much employer-contributed money in the account you get to keep if and when you leave. If your company matches contributions, but the contributions are subject to a short vesting schedule, or if you plan to work there for a long time, consider contributing the minimum amount needed to receive the full company match each year. But what if you don’t plan on working for your employer for long? Or, what if the contributions are subject to a lengthy vesting schedule? In that case, getting a match should not be as much of a determining factor. Likewise, matching contributions won’t be a factor in your contribution amount if you are self-employed and set up a solo 401(k) for yourself.
Your Current Age
If you are younger and have more time until retirement, you can make smaller contributions toward your 401(k) and still meet your retirement goals. But it’s best to save as much as you can for retirement, as early as you can. This can help you take advantage of compound returns over time. It will benefit your nest egg to save aggressively now if you can afford it. In contrast, the older you are, the less time your assets have to grow until you start withdrawals. That means you may need to save more aggressively to meet your goals. You may need to contribute larger amounts. And you also may need to take advantage of catch-up contributions. But if you have steadily saved over the years and are already on track with your retirement goals, you may be able to get by with the same percent of your income you’ve been saving each year.
How Much Is in Your 401(k) and Other Accounts
A 401(k) plan may be only one part of your bigger retirement strategy. You may also have money in an IRA, pension plan, or other types of accounts. Take a look at all these accounts and their current balances. Then, you can figure out what role your 401(k) will play in sustaining your retirement income. For instance, let’s say you have assets in an IRA. In that case, you may be able to contribute less to your 401(k). Higher plan contributions make sense if the 401(k) makes up the bulk of your retirement assets. That’s because you will be more dependent on that account for income in retirement. Retirement income calculators can help you estimate the amount you need to save. Once you have an estimate, look at how much is in your 401(k) and other retirement accounts. Then, compare that to the balance you think you’ll need to retire. Finally, decide how much you want to contribute to a 401(k) plan on an annual basis to meet your goal.
What Are the Tax Implications of 401(k) Contributions?
Once you figure out how much to put into your 401(k), take a look at the different contribution types. Each has a unique tax treatment.
Traditional 401(k) Tax Implications
Pre-tax 401(k) contributions are not included in your taxable income for the year. They can lower your tax liability for the tax year in which you make the contribution. But you will pay income taxes, and possibly penalties, on withdrawals from a traditional pre-tax 401(k) plan. This type is best if you are in a higher tax bracket in the years you are making contributions and expect to be in a lower tax bracket when you withdraw money from the 401(k) plan. What if you already have a lot of money in tax-deferred accounts? In that case, you might want to do more long-term planning before deciding if you should contribute even more pre-tax money to the plan.
Roth 401(k) Tax Implications
A Roth 401(k)’s contributions are made after taxes and grow tax-free. A Roth 401(k) is a distinct type of 401(k). It allows you to contribute after-tax funds. These contributions are best if you think you may be in a lower tax bracket in the year you make the contributions and a higher tax bracket when you take withdrawals. Roth 401(k) contributions are a good choice if you have a long time to let the money grow tax-free. They can also be the right choice if you already have substantial pre-tax savings and want to build up more money in after-tax accounts. After-tax contributions offer tax-deferred growth, but the gains are taxable upon withdrawal. Only some 401(k) plans allow after-tax 401(k) contributions. These are different from Roth contributions. You can’t take a deduction for after-tax contributions; you must include them in your income. Also, at the time you withdraw these contributions, you will be taxed only on any gain. You have already paid income tax on the amount of the contributions themselves, so you will not pay income taxes on this amount when you withdraw it.
When Should You Change Your 401(k) Contribution Amount?
Once you’ve decided how much to contribute to your 401(k), revisit the amount you contribute to the plan from time to time. It’s good to be aware of how your income changes and how the plan limits change. Don’t use your 401(k) for purposes other than retirement. Taking out 401(k) loans or making early withdrawals for other expenses robs you of investment gains that you’ll need later in life.
The Bottom Line
If your short-term financial needs are being met, contribute as much as you can afford to a 401(k) plan to meet your retirement goals. But aim for a minimum of 10% to 15% of your income. In addition, take into account contribution limits, matching contributions, your age, and your retirement portfolio before you decide how much of your income to direct to your 401(k) plan or other retirement accounts. Then, consider the tax implications of making different types of 401(k) contributions. Your retirement plan should ideally amount to more than just your 401(k) account. If you can afford one, a financial planner can help create the comprehensive plan needed for you to enjoy a financially stable retirement.
