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A 401(k) can be the most powerful way to save for retirement. Employers that offer a 401(k) offer lots of automated features that can make it easy to get going, but there are key steps you can take that will wring the most value out of a 401(k). A 401(k) is the tax-advantaged account where…
A 401(k) can be the most powerful way to save for retirement. Employers that offer a 401(k) offer lots of automated features that can make it easy to get going, but there are key steps you can take that will wring the most value out of a 401(k).
A 401(k) is the tax-advantaged account where you can store away money for your retirement. In 2019, anyone younger than 50 can contribute up to $19,000 to a 401(k). That’s more than triple what you can save in an IRA. If you’re at least 50 years old, you can contribute $25,000 to a 401(k) in 2019.
Granted, that’s a lot, but if you’re nervous about your retirement security, scaling back your spending (maybe downsizing) can free up money for turbo-saving in your 401(k). Even if you’re not yet ready to shovel the annual max into your 401(k), there are simple strategies you can use right now to make the most of your account:
Make sure you qualify for the maximum match. If you have job-hopped in the past five or so years your new employer may have automatically enrolled you into a 401(k) plan. That’s a well-intentioned move to get you saving for retirement. However, you should check how much of your salary you are contributing. Many employers set the contribution rate at just three percent or so of your annual salary. In most cases, that’s not nearly enough to earn the maximum matching contribution.
For instance, it’s common for employers to offer to match a portion of an employee’s contribution, up to a maximum of six percent of their salary. If you are only contributing three percent, you aren’t going to earn the maximum match. Confirm that your contribution is at least enough to earn the maximum match. That’s the absolute lowest rate you should consider.
Aim to contribute 15 percent of your salary. Earning enough to get the maximum employer match is just the bare minimum. According to retirement planning pros, what you really want to aim for is to save 10 percent of your pre-tax salary. If you want to play it safer, or you are already in your 30s and have yet to get serious about saving, you want to get to 15 percent ASAP.
If you can’t cold-turkey your way to 10 percent to 15 percent, hatch a plan to raise your contribution rate. Some plans offer an “auto-escalation” feature. Make sure you are signed up. Or create your own plan for increasing your savings rate. For instance, vow to raise it two percentage points every year, until you reach your target rate. Set a date to make the change; maybe your birthdate or your work anniversary.
And every time you get a raise, promise yourself to use at least half of it for retirement savings. For instance, if you get a 5% raise, increase your 401(k) contribution rate by 2.5 percentage points.
Consider a Roth 401(k). Many 401(k) plans now offer two ways to save: A Traditional 401(k) or a Roth 401(k). The difference between the two is when you pay taxes. A Traditional 401(k) is the “original” 401(k). When you make a contribution it reduces your taxable income for the year. Then in retirement, every penny you withdraw will be taxed as ordinary income. With a Roth 401(k), there is no tax break on your contribution. Your contribution is made from the salary that has already been taxed. In retirement, all money you withdraw from a Roth 401(k) is 100 percent tax-free. With a Roth, you are essentially front-loading your tax bill.
Ask any CPA what’s best, and you will likely be steered to the Traditional 401(k) because a CPA’s job is to reduce your taxes this year. But consider what would be better for the long-term. Financial advisors increasingly recommend having at least some 401(k) savings in Roths, as a “tax diversification” strategy for retirement. Having some tax-free income in retirement can help keep your tax bill lower.
If you’ve been saving for years in a Traditional, you might consider spending a few years contributing to a Roth. Just contact the plan and tell them where you want current contributions to go.
Find the Right Mix of Stocks and Bonds. Your 401(k) is all about the long-term. Even if you are 55 your goal should be to build a portfolio allocation strategy that can support you at least to age 90. If you don’t want to figure out the allocation stuff on your own, your 401(k) likely offers a simple way to land at a smart mix of stocks, bonds and cash: a target-date retirement fund (TDF).
Each TDF has a specific year in its name. Acme TDF 2030, Acme TDF 2045 etc. Pick a TDF with a year that is close to when you expect to retire, That’s it, you’re done. That single TDF will invest in a mix of stocks, bonds and cash. If you’re in your 20s, 30s and 40s it will tilt more toward stocks, and in your 50s and 60s will move more of the portfolio into bonds and cash.
Don’t Overload on Company Stock. Some companies with publicly traded stock, make their stock available in the 401(k) plan. In years past, many employers made their matching contributions in company stock. Be careful. It is risky to keep more than 10 percent of any investment portfolio in one stock. That’s not a bet against your employer, it’s smart portfolio risk management.
Hands Off Until Retirement. A dangerous quirk of 401(k)s is that when you leave a job you are allowed to cash out your 401(k). That’s typically a really bad move. You will likely owe a 10 percent early withdrawal penalty, and income tax if you had a Traditional 401(k). Earnings on a Roth 401(k) withdrawal you take out early will also be subject to tax.)Moreover, money you cash out today is money you won’t have for retirement.
About the author
Carla translates business and personal finance concepts into engaging content that helps individuals make more confident choices in how they manage their money. Her work appears in The New York Times, Money Magazine, Barron's and Consumer Reports.