Why is your 401(k) so important? If you are contributing to a 401(k) plan, you probably enjoy seeing those savings increase 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 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 another large purchase, or as a place where you can borrow money for your child’s education.

Not so fast: Your 401(k) is one of the best ways you have to save for retirement. 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, but it is likely to become a critical piece of your retirement income pie; most people do not have another retirement option from their employer. For these reasons your 401(k) is more important than you might think.

Key Takeaways

  • 401(k) accounts have significantly higher maximum contribution limits than IRAs.
  • If your 401(k) has an employer matching contribution, that money does not count toward the contribution limit.
  • If you don’t contribute enough money to your 401(k) to trigger your employer’s matching contribution, you are virtually throwing away free money.

Saving for Retirement With a 401(k)

In the past many private-sector employees could depend on a defined-benefits pension from their employer, but that possibility is quickly fading. In 1980, 60% of employees were eligible for a pension from their employer. That number fell to just 4% in 2017. Meanwhile, as of December 2018, American 401(k) plans 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 account (IRA) accounts 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 workers born 1960 or later—it will only replace about 40% of your income. 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.

Taking money from your 401(k) prior to age 59½ usually results in a 10% withdrawal penalty (there are certain exceptions), and the amount you take is subject to income tax. All this means that draining—or even taking small amounts from—your 401(k) before you retire will have a negative effect on your financial health in retirement. By contrast, leaving it there allows all your savings to earn income tax free.

$5.2 Trillion

The amount in American 401(k) plans as 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 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 provided 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 $1,461 in 2019. (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 $2,478.

Taking funds from your 401(k) prior to retirement inevitably impacts your solvency in retirement negatively.

Why Your 401(k) Matters

If the retirement income outlined above isn’t enough for your needs, 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 in what is known as a catch-up contribution. The maximum limit for an IRA is $6,000 in 2019, plus another $1,000 if you are 50 or older via a catch-up contribution. 

In addition to the savings cap differential, the other big benefit of maximizing the amount you put in your 401(k), if your job has this, 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 away free money. By the way, that matching money does not count toward your contribution limit.

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 your contribution up to 3% of your salary, 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 do they lose this tax-advantaged savings for retirement, but they have also given up $900 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 contribute 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, roll it over into an IRA (or your new employer’s 401(k), if it’s permitted and you think that makes more sense), This way, the money will continue to grow for retirement. Contribute as much as you can to maximize 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.”