Creating a financial plan early puts you on track to enjoy the happy and comfortable retirement you want. Retirement savings vehicles, such as a 401(k), help you start stowing funds away for the future. The contributions you make to your 401(k) today have a large impact on what your retirement will look like.
Understanding the benefits of a 401(k), as well as how much you can contribute to your 401(k) annually, helps you create an informed financial plan for a stress-free retirement. Read on to learn how to determine your 401(k) contribution and how it can affect your taxes.
401(k) as a retirement savings tool
There are many different retirement accounts that you can choose from to plan your future. A 401(k) is an employer-sponsored retirement savings vehicle that allows employees to plan for their retirement. When you sign up for a 401(k) with pre-tax dollars, you agree to deposit a percentage of your income, called an elective-deferral contribution, into an investment account. Your employer may match some or all of your contribution, thereby accelerating your retirement savings.
There are differences between a traditional 401(k) and a Roth 401(k). When you contribute to a traditional 401(k), you receive the income tax deduction on your contribution now and pay taxes when you withdraw funds in retirement. With the Roth 401(k), contributions are funded with after-tax dollars, meaning you will have to pay income tax on your contributions now, but when you withdraw funds in retirement they are income tax-free.
A 401(k) also differs from other retirement savings vehicles, such as an Individual Retirement Account (IRA) or Roth IRA, which are set up independent of your employer.
Regular contributions to your 401(k) is a way to accelerate your retirement savings because you’ll earn interest tax-free and benefit from matching contributions from your employer. As you decide how much to contribute to your 401(k), consider how much money you will need to live on in retirement.
|How Much Do You Need for Retirement?|
|In general, experts recommend that you will need 80% of your pre-retirement income once you retire. However, your needs may differ depending on your financial situation, for example, if you will still have a mortgage when you retire. Consider how much you will be making in retirement, and what your expenses will be, to determine what you’ll need.|
What percentage should I contribute to my 401(k)?
Contributing to your 401(k) puts you on track to achieve the retirement you want. However, you'll want to consider several factors as you decide how much to contribute, especially if you are relatively new to retirement savings.
As you set savings targets, consider:
Your income and basic expenses. This will provide insight into how much money you may have available to save.
Your other savings goals. Generally, money placed into a 401(k) cannot be withdrawn until age 59.5 without incurring a penalty. Ensure you leave room in your budget for easily-accessible savings, such as building your emergency fund, as well as longer-term goals.
Your current age and the age at which you plan to retire. Contributing to your 401(k) early allows you more time to accumulate returns. However, you may opt to start with a smaller goal that feels manageable now, then ramp up your contributions as you get closer to your retirement age.
No matter how much you choose to contribute, creating a contribution plan now can help ease your financial stress about the future and build your confidence when thinking about retirement.
Dedicate a percentage of your salary
Contributing a percentage of your annual salary allows you to scale your ideal contribution as your income grows, so saving for retirement feels manageable. Start with a percentage that feels comfortable, then increase the contribution percentage as needed.
Even a small percentage adds up over time. For example, an employee earning $120,000 annually who contributes 5% of their income to their 401(k) will save $6,000 annually. After 35 years, they will have contributed $210,000 to their 401(k) — and assuming a 5% annual rate of return on their investment, they will have accumulated $556,489 in their 401(k), not including the employer match.
Take advantage of company matching
Many companies offer contribution matching, which means your employer will match a percentage of your contributions to your 401(k). These contributions add to the total value of your 401(k) and will provide even more security in retirement.
If the employee above, for example, has an employer who will match 50% of their 401(k) contributions, up to 6% of their salary, the company will contribute an additional $3,000 to their 401(k) each year.
After 35 years, the company will have contributed $105,000 to their 401(k), and the employee will have accumulated $834,734 total — over $278,000 more than if they did not have company matching.
How much can I contribute to my 401(k)?
While experts generally recommend saving as much for retirement as possible, the Internal Revenue Service (IRS) limits how much you (and your employer) are able to contribute to your 401(k) each year. Understanding these limits can help you set goals accordingly and avoid the penalties and taxes that can come with overcontribution.
Maximum contribution limits
When determining how much to contribute to your 401(k), consider these three limits:
A salary deferral limit that caps employees’ contributions. In 2020 and 2021, employees can contribute $19,500 to their 401(k)s annually, plus $6,500 for employees aged 50 and over. This limit does not include contributions from your employer.
An annual compensation limit, which caps when you stop deferring a percentage of your pay. In 2021, the limit is set to $290,000.
A total compensation limit, including employee and employer contributions. For 2021, your total contributions must not exceed $58,000 or be greater than your pay — whichever is less.
What should I do when I max out my 401(k)?
You can continue to grow your retirement savings, even after you’ve maxed out your 401(k) contribution. Consider storing money in other retirement savings vehicles, such as a traditional IRA or Roth IRA, to maximize retirement savings. Or consider lower-risk investment opportunities, such as municipal bonds or fixed index annuities. A wealth manager can help you understand the investment opportunities available to you, so you can make an informed decision.
When to start contributing
When it comes to retirement savings, experts recommend you start saving early. Contributing to your 401(k) early offers tax advantages since your savings can grow tax-free for decades. Doing so also allows more time for your savings to accumulate returns, so you have more money available in retirement.
Start with a savings goal that feels manageable now. You can always revisit and readjust your goal later.
Increase contributions over time
Even if you’re starting small with your contributions, they can grow over time. Saving a smaller percentage when you’re young can help you juggle competing financial priorities, such as saving for a home, while also preparing for the future.
As your income grows and your financial situation evolves, you can set more aggressive savings goals for your 401(k). The more you can ramp up your contributions, the better, as the amount you contribute plays a large role in what your life will look like in retirement.
401(k) contributions and tax impact
Contributing to your 401(k) offers a number of tax advantages. For traditional 401(k) accounts, contributions and earnings are tax-deferred, which means you do not have to pay taxes on your savings until the funds are withdrawn.
However, keeping your money in your 401(k) until retirement is the best way to avoid taxes or penalties.
Keep your money where it is
Withdrawing funds from your 401(k) early — before age 59.5 — comes with tax liabilities and penalties. You will be required to pay income tax on withdrawn funds, as well as a 10% early withdrawal penalty.
Don’t pull your money out of your 401(k), even if you switch jobs. You’ll have the option to store your funds in your old employer’s plan, transfer the money to your new employer’s plan, or potentially roll the funds into an IRA.
Final thoughts: Help is available
Saving for the future may feel intimidating, and if you’re struggling to create a retirement savings strategy, help with managing your 401(k) retirement plan is available. Consulting a financial advisor can help you assess your personal finances, overcome obstacles and set realistic goals, both for the present and the future.