Should You Contribute to a 401(k) Plan, and How Much?

Find out if a 401(k) is right for you and what amount to put in

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In general, contributing to a 401(k) plan account is a smart idea for your financial future. Experts recommend kicking in a minimum of 10% to 15% of your income to the plan every year. But there are situations where your money would be better spent elsewhere or where it may make sense to put more or less into your 401(k) plan.

When It Makes Sense to Contribute to a 401(k)

These plans are designed to help employees and the self-employed save for the long-term goal of retirement. The assumption is that if you're saving for retirement, your financial needs have been met. As such, you should only contribute to your 401(k) plan if:

  • You have an emergency fund: This might be a savings account or another deposit account. Having an emergency fund amounting to three to six months' worth of expenses can help you avoid the need to take distributions from your 401(k), which can increase your tax bill in the current year if it's a traditional 401(k) and may incur an additional early withdrawal penalty of 10% if you are not yet 59.5 years of age.
  • You have adequate insurance coverage in place: This includes appropriate health insurance, property/casualty insurance, and life insurance.
  • You have a plan for paying down debt: If you have debt with high interest rates, you may want to consider paying it down before saving aggressively for retirement.

Your 401(k) contributions are for retirement—not for emergencies, a new car, or anything else. If you don't already have the short-term reserves to pay for these expenses, consider putting your money into more liquid deposit accounts that you can readily withdraw from when the need arises.

As a non-liquid account, a 401(k) is not such an appealing savings vehicle if you need the money earlier than retirement. If you lose your job, change jobs, or a health problem arises, you may not be able to access your 401(k) money when you need it. Even if you can, the taxes and penalties may be hefty.

How to Decide on a 401(k) Contribution Amount

Use these criteria to figure out how much of your income to put into the plan.

401(k) Contribution Limits

First and foremost, stay within the legal limits on 401(k) contributions. Under IRS guidelines, employees can contribute a maximum of $19,500 to a 401(k) plan in 2021. If you're 50 or older, you can put in an additional $6,500 in "catch-up" contributions, for a total of $26,000 for the year.

These limits apply to employee contributions for both employer-sponsored and self-employed 401(k) plans. But if you participate in a self-employed plan, you can additionally contribute as an employer up to 25% of your net self-employment earnings.

Company Match

If you work for a company, find out if it provides any form of matching contributions to your 401(k) plan. Depending on the match formula, your employer will partially or fully match your contributions to the plan up to a certain amount.

For example, let's say that your employer offers a 100% match of your contributions for up to 5% of your salary. If you contribute 5% of your income to your 401(k) plan, the firm might match these contributions $1 for $1. This provides you an instant 100% return on any 401(k) contributions you make, up to 5% of your income—free money that will continue to grow in your account until you withdraw it in retirement.

Company matching contributions to your account are often subject to a 401(k) vesting schedule, which is a timeline that dictates how much employer-contributed money in the account you get to keep if and when you leave. If your company matches contributions, but the contributions are subject to a short vesting schedule, or if you plan to work there for a long time, consider contributing the minimum amount needed to receive the full company match each year.

If, however, you don’t plan on working for your employer for long, or if the company contributions are subject to a lengthy vesting schedule, then matching contributions should not be as much of a determining factor when deciding how much to contribute to your 401(k) plan. Likewise, matching contributions won't be a factor in your contribution amount if you are a self-employed individual who set up a simplified 401(k) plan for your business.

Your Current Age

If you are younger and have more time until retirement, you can make a smaller annual contribution (10%, for example) toward your 401(k) and still meet your retirement goals. However, experts recommend saving as much as possible for retirement as early as possible in life to take advantage of compound returns over time. This means that it will benefit your nest egg to save aggressively now if you can afford it.

In contrast, the older you are, and the less time your assets have to grow until you start withdrawals, the more aggressively you may need to save to meet your retirement goal. You may need to contribute 15% or more and take advantage of catch-up contributions. If, however, you have steadily saved over the years and are already on track with your retirement goals, you may be able to get by with lower contributions.

How Much Is in Your 401(k) and Other Accounts

A 401(k) plan may be one savings vehicle in your overall retirement strategy. You may also have money in an IRA, pension plan, or other retirement accounts. Take inventory of all these accounts and their current balances so that you can determine what role your 401(k) will play in sustaining your retirement income.

For example, if you already have substantial assets in an IRA, you may be able to contribute less to your 401(k). If the 401(k) makes up the bulk of your retirement assets, higher plan contributions make sense, because you will be more dependent on the account for retirement income.

Online retirement income calculators, such as Vanguard's calculator, can help you estimate the amount you need to save before you can retire. Once you have an estimate of how much you need to retire, evaluate how much is in your 401(k) and other retirement accounts versus the balance you think you'll need to retire. Then, determine how much you want to contribute to a 401(k) plan on an annual basis to meet your retirement income goal.

Tax Implications of 401(k) Contributions

Once you determine how much to put into your 401(k), choose from the different contribution types. Each has a unique tax treatment.

Pre-tax 401(k) contributions are not included in your taxable income for the year. They can lower your tax liability for the tax year in which you make the contribution, but you will pay income taxes on withdrawals from a traditional (pre-tax) 401(k) plan. This type of 401(k) contribution is best if you are in a higher tax bracket in the years you are making contributions and expect to be in a lower tax bracket when you withdraw money from the 401(k) plan. If you already have a lot of money in tax-deferred accounts, you might want to do more long-term planning before deciding if you should contribute even more pre-tax money to the plan.

Having too much money in tax-deferred accounts can hurt you if you are in a higher-income tax bracket in retirement.

Roth 401(k) contributions go into the 401(k) after taxes and grow tax-free. Roth 401(k)s are a distinct type of 401(k) that allow you to contribute after-tax funds. These contributions are best if you think you may be in a lower tax bracket in the year you make the contributions and a higher tax bracket when you take withdrawals. Roth 401(k) contributions are also an attractive choice if you have a long time to let the money grow tax-free, or if you already have substantial pre-tax savings and want to build up more money in after-tax accounts.

After-tax contributions offer tax-deferred growth, but the gains are taxable upon withdrawal. Only some 401(k) plans allow after-tax 401(k) contributions, which are different from Roth contributions. You can't take a deduction for after-tax contributions; you must include them in your income. Moreover, at the time you withdraw these contributions, you will be taxed only on any gain. You have already paid income tax on the amount of the contributions themselves, so you will not pay income taxes on this amount when you withdraw it.

Depending on your tax bracket, it may make sense to make some pre-tax 401(k) contributions and some after-tax or Roth 401(k) contributions to balance tax benefits now with tax liabilities later. Proper tax planning can help you decide what is appropriate for you.

When to Change Your 401(k) Contribution Amount

Once you've decided how much to contribute to your 401(k), revisit the amount you contribute to the plan from time to time, depending on how your income changes and how the plan limits change.

Most important: Don't stop contributing to the plan, and don't use it for purposes other than retirement. Taking out 401(k) loans or making early withdrawals for other expenses robs you of investment gains that you'll need later in life.

The Bottom Line

If your short-term financial needs are being met, contribute as much as you can afford to a 401(k) plan to meet your retirement goals. But aim for a minimum of 10% to 15% of your income. In addition, take into account contribution limits, matching contributions, your age, and your cumulative retirement portfolio before you decide how much of your income to direct to your 401(k) plan versus other retirement accounts. Then, consider the tax implications of making different types of 401(k) contributions.

Your retirement plan should ideally amount to more than just your 401(k) account. A financial planner can help create the comprehensive plan needed for you to enjoy a financially stable retirement.