People are increasingly on their own when it comes to providing for their retirement. Traditional pensions managed by employers are all but unheard of outside of public service and certain unionized industries. The pension’s primary replacement, the 401(k) plan, transfers the saving and investing responsibilities (and risks) to individual workers.
So, when it comes to the opportunities offered by employer-sponsored plans such as 401(k)s, it’s vital that workers, savers, and investors—and you should see yourself as all three—make the most of them.
While the 401(k) has some differences compared to other plans, such as 403(b)s, most of the planning advice below applies across all the major plans in the United States, be they 401(k)s or individual retirement accounts (IRAs).
- Consistent saving and compounding over time are the keys to the successful growth of your retirement funds.
- Always be sure to contribute at least enough to a 401(k) to qualify for any matching contributions from your employer.
- Be aware of the underlying costs and fees of the various investments within your retirement plan.
- You can contribute to both a personal IRA and a 401(k) plan at work, up to set annual limits.
- You may be able to choose either a 401(k) plan or a Roth 401(k) plan; each offers a particular tax advantage.
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 2022, the maximum contribution limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan is $20,500. In 2023, the contribution limit increased to $22,500. There’s also a catch-up contribution of $6,500 in 2022 and $7,500 in 2023 allowed if you’re age 50 or older.
Your employer can contribute to your 401(k), although not all do. For 2022, the combined annual limit (the sum of your own and your company’s contributions) is $61,000, or $67,500 with the catch-up amount. For 2023, this limit is up to $66,000, or $73,500 with the catch-up amount.
Roth 401(k) vs. 401(k)
Your employer may offer you a choice between a traditional 401(k) and a Roth 401(k). The contribution limits are the same, but the Roth 401(k) is funded with after-tax dollars, as is a Roth IRA.
The traditional 401(k) gets you an immediate tax break. Your gross income for the year is reduced by the amount you pay into your account. You’ll only owe taxes on that money when you withdraw it.
The Roth IRA collects the income tax owed immediately. You won’t owe more tax when you make withdrawals, whether it’s the money you paid in or the profits it earned.
Either 401(k) option is an important way to save for retirement. The traditional option gets you a useful tax break during your working years. The Roth gets you a tax-free source of retirement funds.
A Roth 401(k), like a Roth IRA, provides savers with a tax break when they start taking withdrawals. Unlike a Roth IRA, it requires minimum distributions once savers turn age 73 unless they are still employed or have 5% ownership in the business associated with the 401(k). (The age increased from 72 on Jan. 1, 2023.)
Max Out Your 401(k)
Can you afford to save the maximum? If so, there is not much more you need to do to enhance your savings, apart from making the best investment decisions you can with the investment options provided by the plan.
If you cannot afford to contribute the maximum amount, whittle it down to what you can contribute. Clearly, expenses such as mortgage or rent payments, utilities, and food need to be covered. It makes little sense to put aside so much that you need to accumulate credit card debt to make it through a month.
If you cannot make the maximum contribution, consider supplementing whatever you can contribute with any bonuses or profit-sharing payments you receive. Many companies allow you to have these amounts deposited directly into your 401(k). Automatic deposits are a good idea because good intentions can go awry once a bonus check is in hand.
Above all, try to be consistent with your savings. Set a specific per-paycheck amount and do not change it unless necessary. Don’t try to time the market or curtail your contributions because the latest economic or political news is gloomy.
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 supplement Social Security down the line and fund a comfortable retirement.
401(k) Employer Match
The employer match, if there is one, will greatly boost your retirement savings. Many employers contribute the same amount of money you contribute, or a percentage of what you contribute, up to a set limit.
This effectively doubles your retirement savings without decreasing your salary or increasing your tax burden. Many employers match up to 3% of your pay.
Need another reason to max out your employer match? Employers calculate their costs and base their staffers’ salaries assuming they take the full match. If you don’t take advantage of this, you’re 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. Frequently, that stock can be sold and converted to cash within a reasonably short period of time and at a reasonable cost.
Required Minimum Distributions (RMDs)
As with some other retirement savings plans, 401(k)s have required minimum distributions (RFDs).
As of Jan. 1, 2023, owners of 401(k) must start taking RMDs at age 73, whether they need the money or not. The IRS is serious about this. There’s a 25% penalty for failing to withdraw the correct amount (and that’s a break from the 50% formerly imposed.)
RMDs don’t apply if an employee is still working for the same employer that sponsors the plan. Also keep in mind that the funds in a Roth 401(k) can be rolled over to a Roth IRA which has no required minimum distributions during the owner’s lifetime.
Owners did not have to take RMDs in 2020, following the passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which temporarily waived distribution requirements for IRAs and other retirement plans. The Act had no impact on Roth IRAs, which don’t require withdrawals until after the owner’s death.
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:
- Cliff vesting refers to an employee going from owning 0% of matching contributions to 100% ownership after a specific amount of time.
- Graduated vesting refers to an employee owning an increasing portion of the matching contributions until they eventually own them all.
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. The company will take back some or all of its matching contributions if you leave 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.
Understandably, many workers feel overwhelmed when it comes to calculating their contributions and investing the money. Just bear in mind that paying for investment advice reduces your account’s value and capacity for growth.
Savers also need to pay 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 and exchange-traded funds for 401(k) plans as well as low-cost index funds. It’s still important to compare and contrast the numbers because fees still vary a good deal.
Along similar lines, investors need to be careful with financial savings tools like annuities and target-date funds.
Annuities arguably do not have much of a place in tax-sheltered accounts to begin with. What’s more, their often high expense ratios can eat away at their value over time. Target-date funds are popular options in many plans, but some charge higher fees than regular funds, without correspondingly better results.
Most plans have provisions that allow employees to borrow funds from their accounts. This money comes relatively free of strings insofar as what the funds can be used for.
For example, you can use your savings to pay off high-interest loans or credit card balances. The money does not come free of charge, but you’re paying the interest to yourself, not a bank.
A 401(k) loan is not a risk-free maneuver. The 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, and opens a Pandora’s box of future financial troubles.
Nonetheless, borrowing low-cost cash from a 401(k) to repay high-cost credit card debt and ultimately invest even more in the 401(k) can be a prudent choice. Just don’t make a habit of it.
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 a plan’s investment choices.
Keep in mind that many employers choose 401(k) plans on the basis of what is cheapest and most convenient to offer. They may not even be aware of its deficiencies.
While it is true that many workers do not like to be a squeaky wheel, doing nothing is a pretty good way to ensure that the plan will not be improved. Some companies are undoubtedly apt to be more responsive than others.
Traditional and Roth IRAs
What do you do if you have maxed out your 401(k) but want to save even more? Thankfully, there are options available to you, including traditional IRAs and Roth IRAs.
You can contribute up to $6,000 to either type of IRA in 2022 and $6,500 to either type of IRA in 2023. If you’re age 50 or older, you can add a $1,000 catch-up contribution.
Traditional IRAs and 401(k)s are funded with pre-tax contributions. You get an upfront tax deduction 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—such as a 401(k)—the tax deduction for your traditional IRA contributions will be limited. With Roth IRAs, the amount you may contribute will be limited by the amount of your annual earnings.
Annuities and Health Savings Accounts
There are other tax-advantaged ways to save after you have maxed out an IRA and 401(k) account. One option is to consider buying and investing in annuities.
Annuities have many advantages and disadvantages. They can carry high sales loads, typically have high expenses, and sponsors have continually transferred more risk to the investor.
That said, money in an annuity can accumulate without year-to-year taxation. It may be a worthwhile option if protecting even more retirement savings from the taxman is essential.
If you have a high-deductible health plan (HDHP), another savings option is a Health Savings Account (HSA). It’s a tax-advantaged vehicle you can use with certain types 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 for saving additional retirement funds.
What Is a 401(k) Plan?
It’s a workplace retirement plan offered by many, but not all, employers. Employees who enroll in the plan make regular payments through payroll deductions. Over the years, they build up a nest egg to supplement their living expenses after they retire.
In order to encourage their use, the government offers substantial tax breaks to employees who participate in a plan. Many employers make contributions to the accounts of employees.
So, the 401(k) plan is a great savings option for working Americans who want a comfortable retirement.
What Happens to My 401(k) Savings If I Leave One Job for Another?
You have several options:
- You can leave your savings where they are (if the balance is above a certain amount).
- You can take your 401(k) savings with you and transfer the balance to your new plan. (Warning: Don’t touch that money! Have your plan administrator transfer the money or you could owe a ton of taxes on the balance.)
- You could move your workplace savings into a rollover IRA that you control. Almost all banks and brokerages offer them.
- You can cash out your plan, but that’s a bad idea. You’ll owe taxes and probably a penalty if you’re under age 591/2. Not to mention your retirement savings will be gone.
Can I Roll Funds From a Traditional 401(k) Into a Roth IRA?
Yes, you can. You’ll have to pay the income taxes due on the amount you roll over that year. That’s because you got the upfront tax deduction on your contributions with the proviso that you’d pay the taxes eventually.
On the other hand, you’ll pay no taxes on your future withdrawals from the Roth IRA. It’s a good idea to inform yourself completely of the rules concerning a rollover so you can be sure to protect your savings.
The Bottom Line
Tax-advantaged retirement savings plans are one of the relatively few tax breaks that the government gives to ordinary workers. Careful saving may not necessarily be a gateway to becoming independently wealthy but it can 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.