In today’s workplace environment, unless you are working as a teacher, police officer, firefighter, or state/federal employee, chances are you do not have a pension plan. In other words, when it comes to funding your retirement, YOYO (you’re on your own). For most private sector employees, defined contribution (DC) retirement plans are their primary savings vehicle. DC plans are a type of retirement plan where an employer and/or employee make regular contributions.
They differ from a pension plan in that there is no guaranteed income stream at retirement. Instead, both the employer and employee contributions, plus any investment earnings, grow together in an account where the employee has control over the cash distributions during their retirement. The most common DC plan is the 401(k) plan, which has grown to become America’s de facto retirement savings plan since its inception in the late 1970s. (For related reading, see: The Basics of a 401(k) Retirement Plan.)
A 401(k) plan is a great savings vehicle for a number of reasons. First and foremost, contributions made by the employee are tax-deductible. Secondly, any earnings in the account grow tax-free until they are withdrawn. Unfortunately many Americans are not taking full advantage of the benefits a 401(k) plan has to offer. There are two primary culprits behind this underutilization: lack of participation and low contribution rates. In order to ensure you are getting the most out of your 401(k) plan, make sure to follow these guidelines. (For more, see: 10 Habits of the Healthy, Wealthy & Wise.)
Start Contributing Early
During your first week of work you will likely be given a large packet of information listing everything from your vacation accrual to your medical benefits. Included in this packet should be an enrollment form for your employer’s 401(k) plan. You should sign up for your 401(k) plan immediately. Some employers may have restrictions on when you can start contributing or an elimination period before the employer matches any contributions; however, these restrictions typically do not prevent you from enrolling in the plan.
If you have already been working but have yet to sign up, there is no time like the present. To borrow a line from a colleague of mine, “You will never be younger than you are today.” When it comes to investing, the longer the time horizon, the greater the growth potential. (For related reading, see: What's the Average 401(k) Balance by Age?)
Maximize Your Employer Match
Most employers will make a modest contribution to your 401(k) plan presuming you do one thing—contribute to the plan yourself. While there is a wide range of company match levels, a typical employer match policy might read something like this: "XYZ agrees to match 50% of employee contributions for the first 6% of salary that an employee contributes." In this scenario, in order for an employee to maximize their employer match, they would need to contribute 6% or more of their salary into their 401(k) plan. Any contribution below 6% means the employer is not obligated to contribute the full match. (For related reading, see: How 401(k) Matching Works.)
Maximizing your employer match is critical to building your retirement nest egg. Not contributing or under-contributing to your own plan means you are essentially throwing money out the window. An employer match is a guaranteed return on investment, which is rare if not impossible to find in this day and age.
Take It to the Limit
The most common way to contribute to a 401(k) plan is through automatic payroll deductions. Many plans allow you to designate a percentage of your gross income to be allocated to your 401(k) plan. A good rule of thumb is to contribute 10% or more of your salary into your 401(k) plan. Unfortunately, for many young or underpaid employees this figure is simply unrealistic. For those who can’t save 10% or more, start off by saving the minimum allowable contribution that enables you to maximize your employer match. Most employer plans require employee contributions between 4% and 8% to receive the maximum match.
Automatic contribution increases are another great way to get the most of your 401(k) plan. As the name infers, an automatic contribution increase is simply an election you make to annually increase your contribution percentage (typically by 1%). The beauty of this election is it forces you to save more each year and they typically coincide with a merit pay increase so the effects are negligible. If your company doesn’t offer this election then remember to manually adjust your contribution percentage each time you get a raise.
Keep in mind that the Internal Revenue Service regulates how much an employee can contribute to their 401(k) plan. In 2016 the contribution limit is $18,000. If you are lucky enough to be age 50 or older, the IRS has a special catch-up provision that allows you to contribute an additional $6,000 for a total contribution limit of $24,000. (For related reading, see: Your 401(k): What's the Ideal Contribution?)