If you are contributing to a 401(k) plan, you probably enjoy seeing those savings increase each year. When you change jobs, you may think of that money as a way to pay moving expenses and other costs connected to starting a new position. Or, you may think of the account as a way to save for a house or other large purchase – or to borrow money for your child’s education.
But wait; your 401(k) is one of the best ways to save for retirement. You should only consider using it for something else if you are hit with serious hardship. Not only are there rules about withdrawing 401(k) money prematurely (see Borrowing From Your Retirement Plan and Are 401(k) loans taxed?), but it is likely to become a critical piece of your retirement income pie, since most people today do not have another retirement option from their employer. For these reasons it is more important than you might think.
Saving for Retirement
In the past, many employees could depend on a pension from their employer, but that possibility is quickly fading. In 1980, 38% of employees were eligible for a pension from their employer. That number fell to just 20% in 2008 and has likely fallen even further today.
That puts even more pressure on the 401(k) to do the heavy lifting for retirement. Some employees have IRA money and other savings to add to the pot, but other than that, the bulk of their income is likely to come from Social Security. Even if you wait to take Social Security at your full retirement age – 66 for most baby boomers, 67 for younger workers – it will only replace about 40% of your income, according to statistics. When you combine that with a well-financed 401(k), you will likely get about 60% of your current income. Yet financial planners recommend that you plan to replace 70% to 90% of your current income if you aim to maintain the lifestyle you enjoy today.
All this means that draining – or even sipping at – your 401(k) before you retire will have a negative effect on your financial health in retirement. (See Retirement Savings: How Much Is Enough? for a look at how different rates of savings can affect your retirement funds.)
Calculating Your Retirement Income
If you are wondering how much income you can expect from a 401(k), the U.S. Department of Labor offers an excellent Lifetime Income Calculator. To give you an example of how this calculator works, we input the retirement age of 66 for a person who is currently 46 and therefore has 20 years to go until retirement. We assumed the employee’s contribution was $100 per month and the employer match was $100 per month for a total annual contribution of $2,400. We also assumed a current account balance of $50,000.
The Lifetime Income Calculator then calculated a projected account balance at retirement of $187,453. The lifetime income per month for the participant would be $1,018. The average Social Security benefit is $1,260. (You can estimate your Social Security income using Social Security calculators.) If these are the only two sources of income, the monthly income at retirement for this person would be $2,278.
Why Your 401(k) Matters
If the retirement income outlined above isn’t enough for your needs, you have to save more aggressively. That’s where your 401(k) assumes greater importance, as it can be a much more effective savings tool than an individual retirement account (IRA). The reason: The maximum you can put into a 401(k) in 2015 is $18,000. If you are age 50 or older, you can put in an additional $6,000. The maximum limits for an IRA are much lower: $5,500 plus another $1,000 if you are 50 or older.
In addition to the savings cap differential, the other big benefit of maxing out the amount you can put in your 401(k) is the match your employer makes toward your contributions, which allows your 401(k) to grow even faster. If you don’t put in at least enough to get your full employer match, it’s like giving money away.
Many employers match 1% to 6% of an employee’s contribution. Here’s an example of how the match works: Let’s say you earn $30,000 per year and contribute 3% of your salary to your 401(k) or $900. If your employer matches up to 3% of your contribution, that would mean the employer’s contribution would be another $900 to match yours. The total going into your 401(k) would be $1,800 per year. If your co-worker makes the same salary and decides not to make a 401(k) contribution, not only does he have no savings for retirement, but he’s also given up $900 of savings he could have received from his employer.
“A 401(k) match is a terrible thing to waste,” says James Twining, founder of Financial Plan, Inc. in Bellingham, Wash. “We have seen employees who are not participating in their company 401(k), and as a result they are throwing away free money from the employer match.”
Want to put away even more for retirement? See 5 Essential Retirement Savings Accounts.
The Bottom Line
Always contribute enough to your 401(k) to get your full employer match. Consider putting away even more, if you can afford it. If you change jobs, don’t spend the money, roll it over into an IRA (or your new employer's 401(k), if it's permitted and you think that makes more sense) so the money will continue to grow for retirement. Contribute as much as you can to max out the value of this critical retirement savings.
“A key to any retirement savings plan, whether it is a company-sponsored plan or an individual retirement account, is to save consistently,” says Brad Sherman, president of Sherman Wealth Management in Gaithersburg, Md. “When creating a budget for yourself, determine the percentage of your salary that you will contribute each month and stick to that plan.”
For more on 401(k) options, see Best Ways to Roll Over Your 401(k) and Top Reasons Not to Roll Over Your 401(k) to an IRA.