It's never too early to start saving for retirement. In fact, for more than half of Americans it's already past time to get started… well past.
Since 1981 the 401(k) has been America's first answer to the question of building toward retirement. Picking up the slack as the costs of longevity and health care outstripped Social Security, the 401(k) program allows people to build a retirement investment account with pre-tax income. While this can give a substantial boost to retirement planning, many financial experts have criticized the 401(k) as woefully insufficient to meet the needs of American retirees.
Among several concerns, the simple structure of the 401(k) program stands out. If you don't have an employer, or if your employer doesn't offer a benefits program, you don't get to invest in a 401(k) retirement account. According to data from the Pew Charitable Trusts, 35% of all private-sector workers don't have access to a 401(k) retirement plan. Most of them are millennials.
This is all the more reason to take advantage of yours if you have one. Despite its limits, a 401(k) plan can help you get a substantial leg up on retirement. If you're lucky enough to have one you should make the most of it. Here's how.
How to Max Out Your 401(k)
Always Meet Your Match
Most employers that offer a 401(k) do so through what is known as a "defined contribution" program. This is by far the most common form of the program, in which you (the employee) dedicate a portion of your paycheck to your retirement account. Some employers will run what is known as an "employer match" program. This means that they will make a matching contribution to your retirement account up to a certain amount.
If your employer offers a matching contribution, always take them up on it. Every extra dollar that your employer invests on your behalf is money that you gain without counting toward your annual contribution limit.
Understand Your Contribution Limits and Benefits
The IRS limits how much pre-tax money you can invest in your 401(k) every year. You are, of course, free to save as much money as you want for retirement in general, but the rest you'll have to pay taxes on first.
General Contribution Limits / Catch-Up Contribution Limits
You can contribute up to $19,000 to your 401(k) if you are age 49 or younger. If you are age 50 or over you can invest up to an additional $6,000 in what is known as a "catch-up contribution," for a total of $25,000 in total 401(k) contributions.
You make this contribution with pre-tax money. This means that it will be deducted from your paycheck before the IRS calculates any income tax that you owe. For example, assume that someone had $100,000 of taxable income. They would owe approximately $15,410 in federal income tax (assuming no dependents, spouse or other relevant factors).
If that same person made the full 401(k) contribution of $19,000, their taxable income would go down to $81,000. They would then only owe $11,120 in federal income tax. The remaining money would be tax-deferred, meaning that they would not pay any taxes on it until withdrawing the profits of their 401(k) account in retirement.
Retirement Savings Contributions Credits
Finally, workers who are not full-time students and not dependents might qualify for the Retirement Savings Contributions Credit. This tax credit allows you to deduct an additional portion of your 401(k) contribution if your income falls below certain thresholds. This program can provide an additional tax deduction of 10% to 50% of your total contribution up to a total of $1,000 (or $2,000 if married filing jointly).
Regularly Budget For Your Contributions
Look, the obvious advice here is to maximize your allowed 401(k) contributions. If you have the financial wherewithal to dedicate $19,000 per year to your retirement, do so. The IRS increases the allowable contribution cap each year, and if possible you should increase your own contributions in kind.
Most workers don't have that flexibility, though.
For people who have to consider what they can afford to contribute, the best advice is to regularly check up on their 401(k) status. Every quarter or so consider how much you are dedicating to your retirement account, compare it to the cap and check to see if you can budget for a little bit more. As you get older, work harder to increase those contributions, and perhaps even consider signing up for an automatic increase plan if your employer offers one.
The standard advice is to try and contribute between 15% to 20% of each paycheck to your retirement account. For many people, this is an enormous amount of money, but it is possible. The median American makes approximately $59,000. This means finding of $9,000 in the budget (less after taxes). It won't be easy, which is why you should make it an active part of your budgeting process. If you treat your 401(k) like a fire-and-forget, it will be easy to miss opportunities to put more money in.
But Do Automate the Process
This might seem like contradictory advice. It isn't.
Your retirement budgeting should be an active part of your financial life. This is something you should look at and consider on a regular basis, particularly since you will want to increase your contributions as you get older. The sweet spot will be if you can get to age 50 with enough room in the budget to start taking advantage of those catch-up contribution tax breaks.
But, once you've decided how much to invest, make it an auto-debit. Don't force yourself to manually make these contributions on a biweekly basis. Instead, have your employer directly deposit your 401(k) contribution into your retirement account. This will save you an enormous amount of hassle, but more important, it will eliminate the room for human error. If you never touch this money you won't be tempted to store it in the checking account for a rainy day and won't risk forgetting to get around to your retirement fund contributions.
Pay attention, watch the money move, but let it move all on its own.
Pay Attention to Costs
Some employers manage every aspect of their 401(k) program, including how an employee's money is invested. Others will offer you a choice of programs and funds into which you can invest your money. If this is the case, pay careful attention.
Every different investment program is different. In particular, they will come with both a range of risk profiles and fees that the broker charges for managing your money.
Consider carefully the risk profile that you would like. At the same time, compare that with how much each 401(k) plan will charge. Sometimes you will have to pay more to get more, and selecting the more expensive plan will get you the results you're looking for. However, management fees are simply money out the window. Be sure you're not paying more than you have to.
Finally, Understand Penalties
Beware of the two most common mistakes people make with their 401(k)s, and the penalties that attach:
Do Not Put in Too Much Money
The IRS means it when they say contributions are capped at $19,000. If you contribute more than this to your 401(k) in a given year the IRS will consider this money an "excess contribution." You will have until that year's Tax Day to remove the money and any profits it generated with no penalty. If you don't, you will be taxed on the money twice. The IRS will tax you on it in the year you made the deferral, then it will tax you on that money when you withdraw it in retirement.
Do Not Withdraw Money Early
You cannot take money out of your 401(k) early. The IRS gives you this tax break for a reason and they don't want people using it as just a free way to invest a little cash on the side. As a result, while the agency does allow you to occasionally take a short-term loan from your retirement account, if you withdraw money before age 55 and don't put it back you will suffer a 10% tax penalty on top of paying all normal income taxes on that money.