Picture yourself 20, 30 or 50 years from now. If you want to see yourself retiring comfortably, then contributing to a 401(k) plan now is a good way to help you realize that goal. That's especially true if your employer offers a match - essentially free money - toward your retirement. But just what is a 401(k) plan, and exactly how much should you be contributing to it?
What Is a 401(k) Plan?
The 401(k) - named after the subsection of U.S. Internal Revenue Code - is a retirement plan sponsored by your employer that allows you to defer, or delay, part of your pay so it can be automatically invested. Depending on the type of plan, you can make contributions with pre-tax money or pay taxes up front and avoid them later on when you draw on the savings.
How Much Should You Contribute to Your 401(k)?
Experts recommend contributing at least 10% and ideally 15% of your monthly salary to your 401(k) plan. There are limits to what you can contribute, though: in 2018 the limit is $18,500 a year. That goes up to $19,000 in 2019, and the amount usually increases with inflation. To someone just starting out, $19,000 may seem a huge chunk of your income.
Remember that you don't have to contribute that much right away. If you're making $50,000 a year, 15% of your salary is $7,500 a year. Unless you're a young adult living with your parents with few expenses and debts, it may be difficult to swing it, but the younger you start seriously contributing to your 401(k), the more likely it is you'll reach your retirement goals.
When to Start Saving
If you haven't started saving yet, don't worry - there are opportunities to catch up. The best thing you can do is to begin contributing the most you're able to, and ideally, the most you're eligible for - or "maxing out" your 401(k) contributions right now.
Of course, when planning your 401(k) contributions, you need to consider how much of your salary you need now to meet monthly obligations like paying your rent or mortgage, paying outstanding loans or other debt, as well as putting some aside in savings for short-term needs.
The general rule of thumb is to keep 50% of your income for essential expenses, allocate 15% for retirement savings and 5% for short-term savings and emergencies.
Even if you can't max out your contributions, making an effort to put in as much as possible as soon as you're able to can make big difference long-term. An additional $200 a month can translate into tens of thousands. The goal is to save as much as you're capable of, keeping in mind that retirement can last more than 30 years, and you may go through periods of unemployment throughout your career during which you may not be able to save at all.
Many Americans have little in the way of retirement savings and rely almost entirely on Social Security for retirement income. However, Social Security may be at risk, as some legislators are trying to cut it in order to deal with ballooning budget deficits.
Even with Social Security as a safety net, the average benefit amount paid monthly by the Social Security Administration is only $1,177, according to the IRS.
How to Set Savings Goals
Setting an achievable goal is an important step in retirement investing. One guidepost you can use is Fidelity's recommendation to have one year's salary saved by age 30, 4x your annual income saved by the time you reach age 45 and 10x your income by the time you reach 67. If you haven't been able to save that much, you can make "catch-up" contributions after age 50 - adding an additional $6,000 above the 2019 contribution limit of $19,000 for a total of $25,000 a year.
To determine how much income you'll need after you retire, consider that, although you may downsize your home or potentially relocate to a more affordable part of the country or even out of the country, there will be unknown factors that are difficult to prepare for.
Looking at your family's average longevity compared with statistics showing people are generally living longer can help you estimate the amount you need to save. Figure that you could need anywhere between 45% to 80% of your current income, multiplied by about 30 years, in order to retire comfortably. Use that to set a goal.
For a ballpark figure on how much you'll want to save, say you are 40 and currently make $80,000 a year, you love your job and hope to work until you're 67, and there is longevity in your family. You may want to target 70% of your annual income, which would be $56,000 a year. If you want to have an annual income of $56,000 until you're 97 years old, then multiply the $56,000 by 30 years, and that's how much you'd need to save by age 67.
That's $1.68 million you will need if you want to retire on about 70% of your income per year until you're 97.
Including gains and employer matches, that means that, on average, your 401(k) plan would need to increasing by $42,500 annually for about 40 years.
Remember that you don't have to contribute the full $42,500 to your 401(k) to meet that goal as long as your investments are making gains and you're taking full advantage of employer matches. Aim for at least 5% a year on average, and look to those gains to contribute to your savings.
You may also get a boost if your company offers a match that you take full advantage of. The important thing is taking the time to think about it, making estimates and committing to making contributions now can make a big difference in your retirement savings. You can easily make adjustments to your contributions as needed.
Take Full Advantage of the Company Match
Making the highest possible contribution to to your 401(k) plan has another advantage - eligibility for the company match many employers offer.
The company match is money your company contributes to your 401(k) plan that you get to keep depending on your company's vesting schedule. Vesting refers to how many years you need to be at the company before you're allowed to keep all or part of the company's contributions to your plan.
The most common company match is about 50 cents for every dollar you contribute to your plan on 6% of your salary. Some of the better plans will match your contributions dollar-for-dollar for all of 6% of your salary and offer vesting as soon as you start working at the company.
But in order for the company to match it, first you have to contribute it to your 401(k) plan. It may hurt to forego 6% of your pay, but choose not to contribute at least as much as your company is willing to match, and you're leaving free money on the table.
Some companies go above and beyond to help secure their employees' futures. If you'd like to work for a company that offers the best match to give you a leg up on your retirement goals, these have the most generous 401(k) matching contributions. ConocoPhillips, for instance, offers a 900% match on 1% of employee contributions and contributes 6% to 9% of eligible employee pay depending on age, vested at 100% immediately as part of its retirement benefits.
Choosing Between Plans: The Traditional 401(k) vs. Roth 401(k)
The money you contribute to a traditional 401(k) is tax-deferred. That means the amount comes out of your annual income before payroll taxes are taken from it. You pay the taxes on your contribution and whatever gains you made on the investment when you withdraw the money from the plan, so if you had very high investment gains, those will be subject to taxes at distribution.
If you withdraw the money before age 59½ or age 55, depending on your circumstances, you will not only be hit with the tax bill but an additional 10% early withdrawal penalty.
There are also rules about what your employer can do with your money (nothing - the money you put in is yours, though the company match is only yours once you're fully vested.) Once your company sends the money to the investment firm after the plan administrator processes your contributions and executes the trades, your employer is out of the equation. Just know that, as with any investment, you can lose money in your 401(k) if the markets tank.
In both traditional and Roth 401(k) plans, once you sign up, your employer offers several different investments, usually through an asset manager like Fidelity or Vanguard. Those investments have varying levels of risk, so you must choose which one is most appropriate for your age and goals. You may also have the option of investing your contribution however you choose through a brokerage window in your account that allows you to buy stocks or ETFs if you're not thrilled with the selection of funds your plan offers.
Most commonly, however, the plan offers mutual funds which allow you to buy bundles of various stocks, bonds or a combination of the two. Funds are either sorted by investment philosophy (value, growth,) size of the companies they invest in (large cap, small cap,) sector or geographic region.
There are also target date or model portfolio options for those who don't want to be troubled with shifting their investments around as they grow older and their objectives change. These often charge higher fees and start out with riskier investments and become gradually more conservative to preserve capital as you approach your retirement age, or the "target date."
If you have no idea how to allocate your money, most funds offer free advisory services. Check on your company's website or ask your human resources department for their contact information. While their goal is most likely to get you to invest in their more expensive products, they can offer general advice for a novice investor.
The Roth 401(k)
Contributing to a traditional 401(k) plan lowers your taxable income, and depending on how much you contribute, that may put you in a lower tax bracket. But being in a lower tax bracket may not mean a whole lot if you don't make much to begin with.
If it's likely that you'll make more money later in your career, then you may want to consider a Roth 401(k), which allows you to pay taxes on your contributions up front and withdraw the money tax-free at retirement.
Even if your salary is high, you may end up paying more taxes under a traditional 401(k) if you contribute a large portion of your salary and have strong investment returns, since both earnings and contributions are taxed when you withdraw your money, or "take a distribution." A Roth 401(k) plan can have a greater tax advantage, since you're not taxed on your contributions or your earnings when you take a distribution after age 59½.
There are plenty of calculators available online to help you determine which type of 401(k) would best suit you depending on your current and expected future contributions and income.
If your plan doesn't offer the Roth option, you can ask your employer to change the plan to add it. The plan must be amended in order for you to make Roth contributions.