It sets you up for retirement. And it offers some big tax benefits. If your employer offers a 401(k) plan, we strongly recommend jumping on the opportunity. creating an account.
First, what’s a 401(k) account? It’s a type of retirement account run by employers. Basically, it lets you set aside a portion of your paycheck into an account that invests your money into various funds. Over time, your 401(k) can gain compound interest and maximize your retirement savings.
Also, some employers will match your contribution up to a certain percentage of what you contribute. In a way, you can think of a 401(k) as extra salary that can help you save for retirement.
Lastly, a 401(k) can offer up some nice tax benefits, whether right away or down the road when you retire. (That’s the difference between a “traditional” 401(k) and a “Roth” 401(k). We’ll cover them both below.)
In all, a 401(k) is a powerful tool for building your retirement. Here, we’ll show you some ways to make the most of yours.
How much can you stash away in a 401(k)?
There are two main ways money gets into your 401(k) – the money you put into it and any matching funds your employer puts into it too. These are called contributions, and there’s a limit to how much you can contribute to your 401(k) each year.
Your contributions
Your contribution is how much of your paycheck you put into your 401(k) account. The contribution limits look like this: for 2024, the cap is $23,000 for those under 50 and $30,500 for those over 50. You can contribute any amount from $0 up to the annual limits. Typically, you choose to contribute a percentage of your pay, but some companies let you kick in a flat dollar amount.
Your company's contributions
You’ll often hear your company’s contributions called an employer match. So, let’s say your employer matches up to 5% of your contributions. It makes sense to contribute 5% of your paycheck so you can take full advantage of that. As a result, 10% of your pay goes toward your retirement – and you only had to contribute 5% of your own pay to get to a full 10%.
Granted, not all companies make contributions. But if they do, company contributions do not affect your annual contribution limit. That’s one more reason to max out any match that your employer offers.
Some important things to know about company contributions
Some of your company’s contributions might not be yours right away. This is known as a vesting period. You might have to work at the company for a certain amount of time for the money to become entirely yours. Matching and vesting rules vary by plan so check with your company.
So, no question about it, contribute enough to get your employer match if possible. It’s a company benefit, so take full advantage. Granted, doing so depends on where you are in life, your other priorities, and what amount makes sense for your retirement. (Your planning team can help with all that.)
Traditional and Roth 401(k) plans – how your contributions are taxed
A 401(k) gets taxed, but you have options. You can pay taxes on your contributions now or later, depending on the type of 401(k) you have.
In a traditional 401(k), you’re not taxed on any money you contribute to your account. Not up front, anyway. You only pay taxes on that money, and any growth it had, when you withdraw your money during retirement. In effect, contributions to a traditional 401(k) plan come out of your paycheck before the IRS takes its cut. You pay less income tax now and your money grows tax-free … again until it’s time to withdraw it.
Another type of 401(k) called a Roth 401(k) flips that script. You pay taxes on your contributions now, yet when you start making qualified withdrawals you get that money, and any growth it had, tax-free.
Be aware that withdrawing funds early has tax penalties. First, you’ll pay federal income tax (and possibly state income tax) on what you withdraw. Additionally, you’ll get hit with a 10% penalty on what you withdrew.
So, when can you withdraw without penalty? That’s usually at age 59 ½. There are exceptions, like if you leave your job due to a disability, your plan gets terminated without a replacement, or you run into financial hardship. Others include birth or adoption, disaster relief, and even certain medical costs. Of course, we can help you navigate any exception if it comes up. Just reach out to your financial planning team.
Which contribution type is right for you?
Traditional 401(k) or Roth, which one will work best for you? Many employers offer both as an option.
Broadly speaking, there’s a philosophy to it. The choice between a Traditional or Roth 401(k) factors several things, like how taxes can change over time, what you value, and what your plans are for the future.
First, let’s look at the financial part of the question. A Traditional account offers immediate tax benefits, but withdrawals are taxed in retirement. Meanwhile, a Roth account calls for after-tax contributions but provides tax-free withdrawals. In all, the decision involves a bet on future tax rates and our ability to predict the future. (Spoiler, we can’t).
Your choice might also reflect what you value now and your vision for the future. Do you want immediate tax benefits or long-term financial security? Are you more concerned with your legacy or your present financial situation? These questions influence our decision-making.
Our typical approach is to recommend a Traditional account when your income is high to reduce your current tax burden. Opt for a Roth account when your income is low to potentially lower your future tax liability in retirement. Do a mix of the two if you're close to the 24% tax bracket.
Of course, your situation is your own. Chat with your planning team for the option that makes the most sense for you.
Finding the right investment strategy for your plan
Let’s start with talking about how, when you open your 401(k), you can select the investment options that are best for you. This happens a couple of ways.
For one, many plans offer investments in mutual funds. These take several forms, typically they let you invest in a mix of U.S. stocks and bonds, international stocks and bonds, and real estate funds. Professional fund managers run different funds with different blends of stocks, bonds, and real estate. With that, they perform differently depending on what the economy and stock market is doing.
For example, if your mutual fund leans heavily into international stocks you’ll want to look at other options if they have a weak forecast ahead. (That’s one more place where we can help you make the choice that’s right for you. It’s also a topic we bring up as part of your personalized roadmap.)
Some 401(k) plans also have other investment options – like company stock. Be sure to check with your employer. Your planning team can look at that as one of your options as well.
Also, you can consider investing in “target date” funds. These funds make investments based on your age and your planned retirement date. They put you on what’s called a “glide path” toward retirement. You take more risk when you’re young and less risk as you approach your target retirement date.
Say you have an estimated retirement date of 2050. That’s still a way off. A target date fund would likely invest your 401(k) money in funds that have a high potential for gains over a long period of time – even if it takes some temporary losses in the short run. As you get closer to your retirement date, the funds switch to investments with lower gains – and lower risk – preserving your money for retirement while still growing it slightly.
So, what happens to my 401(k) if I change jobs?
Your 401(k) plan is offered through your employer, but when you leave that company it doesn’t mean losing your plan. This is where the idea of a 401(k) rollover comes in.
You could keep your old 401(k) plan with your old employer, yet ideally your new employer will offer one as well. That way, you get all the benefits of matching contributions from your new employer. A direct rollover makes the most sense, where you move funds from the old account to the new.
If your new employer doesn’t offer a plan or if you’re moving into self-employment, you still have options. You can move your money into an IRA and make contributions there.
One thing we recommend strongly against is cashing out your 401(k) early. As we pointed out above, that can cost you heavily in taxes and penalties.
The good news is that rolling over a 401(k) is typically straightforward. As with everything else, we can help you decide what works best for you and then help you make that move.
How your 401(k) figures into your bigger life picture
After reading this article, you can see what makes 401(k) plans so popular. Many people build their retirement savings around a 401(k) plan because it’s a powerful money-building tool with great tax benefits when you manage it right.
Part of that is reviewing your strategy every year. You might want to adjust your investments, savings, and contributions based on your age and how your investments are doing.
We’re here to help with all of that. Our aim is to make contributing to your 401(k) simpler – and in a way that can build a brighter financial outlook both now and down the road. Reach out to your planning team any time you have questions.
