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

Learn about some of these situations so you can ensure you're making the best decisions you can.

Key Takeaways

  • Once you've created an emergency fund, are fully insured, and are paying down your debt, you should be saving for retirement in a 401(k).
  • The amount of your 401(k) contributions should take contribution limits, company match, your age, and other retirement accounts you have into consideration.
  • Be aware of the tax implications of 401(k)s, including whether you should make before- or after-tax contributions.
  • Put as much money into your 401(k) account as you can, but diversify your retirement financial plan.

When Does It Make Sense to Contribute to a 401(k)?

401(k) plans are meant to help employees and the self-employed save for 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 with enough money to cover three to six months' worth of expenses can help you avoid the need to take distributions from your 401(k). If you do that, it can increase your tax bill in the current year if it's a traditional 401(k). You also may incur an early withdrawal penalty of 10% if you are not yet 59 1/2 years old.
  • You have enough insurance coverage in place: This includes 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 pay it down before putting a lot of your money toward retirement. But even if you're working on paying down debt, it's still important to save for the future. do both.

Remember: Your 401(k) contributions are for retirement. That means that money is not for emergencies, a new car, or anything else. If you don't already have the short-term reserves to pay for these expenses, you could put your money into more liquid deposit accounts. That way, you can readily withdraw from them 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 have a health problem arise, 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 Do You Decide on a 401(k) Contribution Amount?

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

401(k) Contribution Limits

Be sure to 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. That gives you 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 have a self-employed plan, you can also contribute 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 instance, 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. This is like free money that will continue to grow in your account until you take it out in retirement.

Matching contributions to your account are often subject to a 401(k) vesting schedule. This 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.

But what if you don’t plan on working for your employer for long? Or, what if the contributions are subject to a lengthy vesting schedule? In that case, getting a match should not be as much of a determining factor.

Likewise, matching contributions won't be a factor in your contribution amount if you are self-employed and 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 smaller contributions toward your 401(k) and still meet your retirement goals. For instance, you could put in 10% per year.

But it's best to save as much as you can for retirement—as early as you can. This can help you take advantage of compound returns over time. It will benefit your nest egg to save aggressively now if you can afford it.

In contrast, the older you are, the less time your assets have to grow until you start withdrawals. That means you may need to save more aggressively in order to meet your goals. You may need to contribute 15% or more. And you also may need to take advantage of catch-up contributions. But if 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 only one part of your bigger retirement strategy. You may also have money in an IRA, pension plan, or other types of accounts. Take a look at all these accounts and their current balances. Then, you can figure out what role your 401(k) will play in sustaining your retirement income.

For instance, let's say you already have assets in an IRA. In that case, 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. That's because you will be more dependent on the account for income.

Retirement income calculators can help you estimate the amount you need to save. Once you have an estimate, look at how much is in your 401(k) and other retirement accounts. Then, compare that to the balance you think you'll need to retire. Finally, decide how much you want to contribute to a 401(k) plan on an annual basis to meet your goal.

Note

You can find many retirement calculators online, such as as the one from Vanguard.

What Are the Tax Implications of 401(k) Contributions?

Once you figure out how much to put into your 401(k), take a look at 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 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. What if you already have a lot of money in tax-deferred accounts? In that case, you might want to do more long-term planning before deciding if you should contribute even more pre-tax money to the plan.

Note

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

A Roth 401(k)'s contributions are made after taxes and grow tax-free. A Roth 401(k) is a distinct type of 401(k). It allows 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 a good choice if you have a long time to let the money grow tax-free. They can also be the right choice 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. These are different from Roth contributions. You can't take a deduction for after-tax contributions; you must include them in your income. Also, 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.

Note

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. This can help you balance tax benefits now with tax liabilities later. Proper tax planning can help you decide what is right for you.

When Should You 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. It's good to be aware of how your income changes and how the plan limits change.

Most importantly: 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 retirement portfolio before you decide how much of your income to direct to your 401(k) plan vs. 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.