When you land your first full-time job, chances are your employer will offer you the chance to contribute to a 401(k). Should you participate? And, if so, how much should you contribute?
If you’re lucky enough to work for a company that offers a 401(k), most financial experts will recommend that you participate in the plan — and that you do so as soon as possible. Here’s why.
Why contribute to a 401(k)?
A 401(k) is an investment plan sponsored by your employer to help you save for retirement.
If you work for a tax-exempt or non-profit organization, or a state or local municipal government, you may be offered a 403(b) or 457 plan, respectively, which share some common features with 401(k) plans, but there are also differences, so be sure to understand the details before you invest.
The main advantages of 401(k) plans include:
- Lower taxes: You get to invest money from your paycheck before taxes are taken out. The money isn’t included in your taxable income amount, which lowers your overall taxes. Be aware there are annual contribution and income limits; make sure you know what they are so you don’t exceed them.
- Automatic savings: As they say, out of sight, out of mind. Since the contribution is deducted directly from your paycheck, you aren’t tempted to spend the money rather than invest it. Your balance continues to build with regularity.
- Matching funds: Many employers offer to match the money you contribute to your 401(k), up to a certain percentage. For example, they may match the first 3 percent of your salary that you contribute as long as it doesn’t exceed $3,000. If your annual salary is $50,000, that’s an extra $1,500 you wouldn't have had without the match.
- A 401(k) can grow by itself: If you begin investing in a 401(k) early enough in your working years, you can benefit from the power of compound interest, meaning that, over time, you’re not just earning interest on your money, you’re earning interest on your interest! That’s when your balance will really accelerate.
- 401(k) money is yours forever: Your balance is portable so, if you end up changing employers, you can have your current 401(k) balance “rolled over” to your new employer’s 401(k) plan and continue to build it up.
Important to note
There are a couple of important things to note about your 401(k).
First, you can’t withdraw money from your 401(k) before a certain age without incurring a financial penalty (after all, the point is to make sure you have a healthy balance when you retire).
The age when you can begin withdrawing is 59-1/2 for most people, 55 in some exceptional cases (consult the current tax code, if necessary).
Second, even though you aren’t paying taxes on your contributions now, you will pay them eventually, as you withdraw money during retirement.
How much should you contribute to your 401(k)?
When you’re young, it’s hard to visualize your life in 30 or 40 years and determine how much money you’ll need.
Just a couple of decades ago, Social Security was plentiful and life expectancies were much lower, making it easier to finance your retirement.
Today, the future availability of Social Security is less certain and, more importantly, people are living longer.
While your grandfather may have lived only 10-15 years in retirement, odds are your retirement years may span 20 to 30 years! That’s a much longer period you’ll need to finance.
For that reason, many experts recommend investing 10-15 percent of your annual salary in a retirement savings vehicle like a 401(k).
Of course, when you’re just starting out and trying to establish a financial cushion and pay off student loans, that’s a pretty big chunk of cash to sock away. You may need to begin at a smaller percentage and set a higher number as your ultimate goal.
Here are a few considerations to keep in mind:
- Catch the match! If you need to start small, at least try to contribute as much as your employer will match. Don’t leave money on the table unless you absolutely have to.
- Increase by one percent annually: Think about raising your contribution one percent each year. That’s an easy formula to follow to maintain consistent growth. See how saving one percent more each year can make a big impact on your savings.
- Work toward 15 percent: By the time you are 40, try to be contributing 15 percent or more of your annual salary.
- Get a reality check at age 50: When you reach 50, review the overall health of your retirement savings. It should be easier now to estimate how much you’ll need and determine whether you’re on track to get there.
- Use your last working decade wisely: If you find a shortfall, consider taking advantage of the higher “make-up contribution” amount the government allows people over 50.
The effect of a few percentage points over time
When determining what to contribute, don’t set your sights too low: A couple of percentage points can make a big difference.
Even if you start small, it’s important to start saving as early as you can and let time do the work of accumulating interest for you. Make a goal to increase your contribution each year and stick to it.
For example, this graph shows how much someone earning $60,000 annually (receiving a three percent raise each year) would save after 30 years, investing at different levels. In this example, a couple of percentage points can be worth more than $150,000 in the end.
Potential value after 30 years
Example is for illustration purposes only. Assumes $60,000 salary, bi-weekly contributions, 3% annual pay increase, and a 7% rate of return. Investments will fluctuate and when redeemed, may be worth more or less than originally invested. Balances shown are pre-tax and are subject to income taxes upon distribution.
Investments will fluctuate and when redeemed may be worth more or less than when originally invested.
This information is a general discussion of the relevant federal tax laws provided to promote ideas that may benefit a taxpayer. It is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. Taxpayers should seek the advice of their own advisors regarding any tax and legal issues specific to their situation.