When it comes to employer-sponsored plans like 401(k)s, it is vital for workers, savers, and investors (and you should see yourself as all three) to make the most they can out of them. While there are some differences with other plans, such as 403(b)s, most of this advice applies fairly well across the major plans in the U.S., be they 401(k)s or individual retirement accounts (IRAs).
- Consistent saving is key to a successful retirement plan.
- Always be sure to contribute enough to a 401(k) to qualify for matching contributions from your employer.
- Be wary of the underlying costs and fees of the various investments within your retirement plans.
People are increasingly on their own when it comes to providing for their retirement. Traditional pensions are all but unheard of outside of the civil service or heavily unionized industries. And both employers and the government have increasingly transferred more and more responsibility (and risk) to individual workers.
The 401(k) plan was designed to fill that void and give workers in the U.S. a tax-advantaged way to save for their own retirement.
401(k) Contribution Limits
For employees who have the ambition and financial wherewithal to make the most of their 401(k), one of the best ways to begin is by working backward. Take your maximum allowable annual contribution, divide it by the number of pay periods in a year, and see where that leaves you.
For 2019 the maximum you can contribute is $19,000. If you’re age 50 or older, you can add $6,000 in annual catch-up contributions. For 2020, the limits bump up to $19,500, with a catch-up contribution of $6,500.
Your employer can contribute to your 401(k), too. For 2019, there's a $56,000 limit on combined employee and employer contributions ($62,000 if eligible for the catch-up contribution). For 2020, the combined limits increases to $57,000, or $63,500 with the catch-up amount.
Roth 401(k) vs. 401(k)
Your employer may give you the choice between a regular 401(k) and a Roth 401(k). The contribution limits are the same, but the Roth 401(k) is funded with after-tax dollars, like a Roth IRA (see below).
Either 401(k) option is an important way to save for retirement. The Roth 401(k) provides taxpayers who earn too much to contribute to a Roth IRA to gain Roth IRA benefits—tax-free distributions, no required minimum distributions in your lifetime—as that money can later be rolled over into a Roth IRA.
Contributions to Roth 401(k)s and Roth IRAs are made with after-tax dollars, while contributions to 401(k)s and traditional IRAs are made with pretax dollars.
Max Out Your 401(k)
Can you afford to save the maximum? If so, there is not much more that you need to do, apart from making the best investment decisions you can within the plan options.
If you cannot afford this amount, whittle it down until you can. Clearly, expenses such as mortgage or rent payments, utilities, and food need to be covered, and it makes little sense to put aside so much that you need to accumulate credit card debt to make it through a month.
Even if you cannot make the maximum contribution, consider supplementing this with any bonuses or profit-sharing payments you receive. Many companies allow you to have these amounts deposited directly into your 401(k). This is a good idea whenever possible—many good intentions have gone awry once a bonus check is in hand.
Above all, try to be consistent. Set a specific per-paycheck amount and do not change it unless you really have to. Likewise, do not try to time the market or curtail contributions just because the economic or political news seems depressing for a while.
If you can, try to save a minimum of 15% of your gross pay. This amount, coupled with reasonable investment returns on those savings, should be sufficient to not only supplement Social Security down the line, but to also fund a comfortable retirement.
401(k) Employer Match
Fully exploiting an employer match is one of the most vital strategies in getting the most out of your 401(k) plan. Matching is pretty much exactly what it sounds like. Subject to certain rules and limits, your employer contributes the same amount of money you contribute, or a percentage thereof.
This effectively doubles your retirement savings without decreasing your salary or increasing your tax burden. Many employer matches kick in once you contribute 3% of your pay (or higher)—so try as hard as you can to make that happen.
Want another reason to max out your employer match? In many cases, employers calculate their costs and base their staffers’ salaries on the basis of full matching. If you don’t take advantage of this, you’re basically handing back free money.
Some employers elect to match your contributions in company stock. While this is not always as desirable as cash, it shouldn’t dissuade you from maximizing your match. Oftentimes, that stock can be sold and converted to cash within a fairly short period of time and at a reasonable cost.
Required Minimum Distributions
Like other retirement savings plan, 401(k)s have required minimum distributions (RMDs). At age 70½, 401(k) owners must start taking RMDs, whether they need the money or not. The IRS is serious about this: There's a 50% penalty for failing to withdraw the correct amount.
However, RMDs don't apply if an employer is still working for the same employer that sponsors the plan. Keep in mind that the funds in a Roth a 401(k) can be rolled over to a Roth IRA—which has no required minimum distributions during the owner's lifetime.
An employer may require a certain number of years of service before its matching contributions belong to the employee. This is called a vesting schedule. In general, there are two types of 401(k) vesting schedules:
The U.S. Department of Labor requires full vesting after six years of service. Still, to get the most out of a 401(k)—and the employer match—it's essential to understand a plan's vesting schedule. Otherwise, the company could take back some or all of its matching contributions if an employee leaves before being fully vested.
As part of some employee retirement plans, workers can avail themselves of investment advice from independent professionals. Unfortunately, this advice is rarely free, and you may find that you pay 1% to 2% of your funds to get this help.
It’s understandable that many workers feel overwhelmed when it comes to calculating their contributions and then investing that money. Still, paying for investment advice is a dicey proposition, particularly when it involves a 401(k) plan, for which investors are given a relatively fixed menu of investment options.
Savers also need to pay careful attention to the costs of the investments they hold within their 401(k). In general, mutual fund expenses have come down over the years, and many fund families offer no-load funds for 401(k) plans as well as low-cost index funds. Of course, it’s important to compare and contrast the numbers, because fees still vary a good deal.
Along similar lines, investors need to be careful with annuities and target-date funds. Annuities arguably do not have much of a place in tax-sheltered accounts to begin with (a topic for another day). What's more, their often high expense ratios can eat away at their value over time.
Likewise, while target-date funds are popular options in many plans, they often (but not always) charge higher fees than normal funds—without correspondingly better results.
For workers who save some funds in a 401(k) but find they cannot contribute more because they are saddled with expensive debt, there may be a counterintuitive option.
Most plans have provisions that allow employees to borrow funds from their own accounts. This money comes relatively free of strings (insofar as what the funds can be used for). And it is possible to use it to pay off high-interest loans or credit card balances. This money does not come free, but the good news is that the interest charged is basically being paid to you.
A 401(k) loan is not a risk-free maneuver. That money has to be repaid on time, or the borrower will incur penalties. Moreover, some workers will find that borrowing from their retirement savings is just a little too convenient, which opens a Pandora’s box of future trouble.
Nevertheless, this can be an effective way to free up more money for savings. It is not for everyone, but borrowing low-cost money from a 401(k) in order to repay high-cost credit card debt and ultimately invest even more in the 401(k) can be a prudent choice.
If you do not like how a plan is organized or the investment options on offer, say so. Complaining about a deficient plan can be an effective means of improving your options (and those of your coworkers).
Keep in mind that many employers choose 401(k) plans on the basis of what is cheapest and most convenient to offer, and they may not even be aware of its deficiencies.
While it is true that many workers do not like to be a squeaky wheel, and some companies are certainly apt to be more responsive than others, doing nothing is a pretty good way to ensure that the plan will not be improved.
Traditional and Roth IRAs
What do you do if you have maxed out your 401(k) or want to save even more by using a well-known investment vehicle? Thankfully, there are many options available to you, including traditional IRAs and Roth IRAs.
For 2019, you can contribute up to $6,000 to either type of IRA. If you're age 50 or older, you can add a $1,000 catch-up contribution. The limits are the same in 2020.
Traditional IRAs and 401(k)s are funded with pre-tax contributions. You get an upfront tax break and pay taxes on withdrawals in retirement. The Roth IRA and Roth 401(k) are funded with after-tax dollars. That means you don't get an upfront tax break—but qualified distributions in retirement are tax-free.
If you or your spouse is covered by a retirement plan at work—including a 401(k)—you can't take the full deduction for your traditional IRA contributions. And with Roth IRAs, you can't contribute if you make too much money.
Other Options: Annuities and Health Savings Accounts
Once you have contributed as much as possible to a 401(k) and an IRA, there are still other tax-advantaged ways to save for retirement. One option is to consider buying and investing in annuities.
There are a lot of advantages and disadvantages with annuities—they can carry high sales loads, typically have high expenses, and sponsors have continually transferred more risk to the investor. All of that said, money in an annuity can accumulate without year-to-year taxation, and it is a worthwhile option if protecting even more retirement savings from the taxman is important.
Another option, if you have a high-deductible health plan (HDHP), is to save in a Health Savings Account (HSA), a tax-advantaged vehicle you can use if you have this type of health insurance. Many investors, particularly higher-income families that can afford to pay the deductibles and young employees in good health, find these accounts helpful in saving additional funds for retirement.
The Bottom Line
Tax-advantaged retirement savings plans are one of the relatively few breaks that the government gives to ordinary workers. Careful saving may not be a gateway to becoming independently wealthy. But it can at least go a long way toward ensuring a more comfortable and pleasant retirement.
Whatever the specifics on offer to you, be it a 401(k), a 403(b), or an IRA, make sure to contribute as much as you can afford and take full advantage of your opportunity to put money away for the future.