If you are contributing to a 401(k) plan, you probably enjoy seeing your savings grow each year. But that feeling may not be enough to truly protect your account—from you.

When you change jobs and that money suddenly becomes available, you may think of it as an easy way to cover your moving expenses and the other costs of starting your new position. Or you may see your 401(k) as a way to save for a house or another large purchase—or as a piggy bank you can dip into for a child’s education.

Not so fast: Your 401(k) is one of the best options you have to save for retirement, so it's smart to leave it alone unless you face a serious hardship. Not only are there strict rules about withdrawing 401(k) money prematurely, but your 401(k) could be the most valuable piece of your retirement income pie someday; most people do not have any other employer retirement plan. For all of these reasons your 401(k) is more important than you might think.

Key Takeaways

  • A 401(k) account is the only employer-sponsored retirement plan available to most people today.
  • If your employer matches your 401(k) contributions, and you don’t contribute enough to collect the full amount, you are missing out on free money.
  • If you make withdrawals from your 401(k) before age 59½, you will generally have to pay taxes and penalties.

Saving for Retirement With a 401(k)

In the past, many private-sector employees could depend on a traditional, defined-benefit pension from their employer. But that was then. In 1980, close to 40% of private-sector employees participated in traditional pension plans. By 2019, that number had fallen to less than 15%.

Meanwhile, 401(k) plans were growing. As of December 2018, they held some $5.2 trillion in retirement assets, or about 19% of all money saved for retirement. That’s up from $2.2 trillion (16% of all retirement assets) in 2008. 

With traditional pensions going the way of the dodo, even more pressure is on the 401(k) to do the heavy lifting for retirement. Some employees have individual retirement accounts (IRAs) and other savings to add to the pot, but for most, the bulk of their income is likely to come from Social Security plus whatever they have in their 401(k)s.

Even if you wait to take Social Security at your full retirement age—66 for most baby boomers, 67 for workers born 1960 or later—it will only replace about 40% of your income. Yet financial planners often say you'll need to replace 70% to 90% of your current income if you aim to maintain the lifestyle you enjoy today. That's where contributing to a 401(k)—and ideally leaving the money untouched until retirement—comes in.

Withdrawing money from your 401(k) prior to age 59½ usually results in a 10% early withdrawal penalty (there are certain exceptions), and the amount you take out is also subject to income tax. Draining—or even taking relatively modest amounts from—your 401(k) before you retire can have serious consequences for your standard of living in retirement.

$5.2 Trillion

The amount in 401(k) plans at the end of December 2018—about 19% of all retirement funds and more than double the $2.2 trillion figure in 2008.

Calculating Your Retirement Income

If you are wondering how much income you can expect from your 401(k), the U.S. Department of Labor offers an excellent Lifetime Income Calculator. As an example of how the calculator works, we typed in a retirement age of 66 for a person who is currently 46 and therefore has 20 years to go until retirement. We indicated that the employee’s 401(k) contribution was $100 per month and the employer match was also $100 per month, for a total annual contribution of $2,400. We assumed the person had been contributing to their 401(k) in previous years and had a current account balance of $50,000.

Based on that information, the Lifetime Income Calculator projected an account balance at retirement of $187,453 and a lifetime income per month of $1,018.

If our hypothetical retiree also received the average Social Security benefit of $1,461 (for 2019) and had no other sources of income, their total monthly income would be $2,479. (You can estimate your Social Security income using these Social Security Administration calculators.) 

Another advantage of a 401(k) over an IRA is its considerably higher contribution limits—currently up to $25,000 per year.

Why Your 401(k) Matters

If you plug your own numbers into that calculation and discover you aren't going to have enough retirement income, you'll need save more aggressively. That’s where your 401(k) assumes greater importance, as it can be a much more effective savings tool than an IRA. Why? The maximum you can put into a 401(k) in 2019 is $19,000. If you are age 50 or older, you can put in an additional $6,000 through what is known as a catch-up contribution. But the maximum limit for an IRA is just $6,000 in 2019, plus another $1,000 if you are 50 or older. 

In addition to the savings cap differential, the other big benefit of maximizing the amount you put in your 401(k) is any match your employer makes toward your contributions. If you don’t put in at least enough to get your full employer match, it’s like passing up free money. By the way, that matching money does not count toward your contribution limit.

Many employers match at least a portion of their employees' 401(k) contributions. For example, let’s say your employer matches 100% of your contributions up to 3% of your salary. So if you earn $40,000 per year, your employer's contribution would add another $1,200 to your 401(k) as long as you contributed at least that much yourself. If your co-worker earns the same salary and decides not to make a 401(k) contribution, not only do they lose a tax-advantaged opportunity to save for retirement, but they have also given up that free $1,200 from your 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.”

The Bottom Line

Always try to contribute at least enough to your 401(k) to get your full employer match. Consider putting away even more if you can afford it, up to your annual contribution limit. If you change jobs, don’t spend the money, Instead, roll it over into an IRA (or your new employer’s 401(k), if that’s permitted and you think it makes more sense). Either way, your money will continue to grow, tax-deferred, for your retirement years.

“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.”