What is a 401(k)?
Updated on Jul 20 2018
A 401 (k) retirement saving plan is one of the smartest investments you can make for your future because you can essentially get ‘free money’ depending on your contributions and your employer offerings. If you are looking to retire within the next ten or so years, consider maximum contributions to your plan to help exponentially grow your assets.
The 401 (k) savings plan is a retirement savings sponsored by an employer to eventually be paid to employees contributing to the plan as a steady income over the course of retirement. The plan helps you save and invest a portion of your paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account.
What are 401(k) plans like today?
Today 401(k) plans have mostly replaced pensions and are one the best tools for retirement savings – which is why it’s so important to educate yourself on your 401(k) plan.
With a 401(k), you control how your money is invested. Most plans offer a spread of mutual funds composed of stocks, bonds and money market investments. The most popular option tends to be target-date funds, a combination of stocks and bonds that gradually become more conservative as you reach retirement.
While a 401(k)can help you save, it has plenty of restrictions and caveats. In most cases, you can’t tap into your employer’s contributions immediately as you have to wait for your employer’s contributions to vest. There are complex rules about when you can withdraw your money, and there are costly penalties and taxes for pulling funds out before your full retirement age.
Typically, employers hire a trusted administrator or investment firm to manage the accounts, including paperwork and direct requests. You’ll receive periodic updates about your plan and its performance and you’ll have access to your account to watch or shift your assets in the market on the administrator’s website.
What is vesting in relation to a 401(k)?
Vesting is the amount of time you must work for your company before gaining access to the company’s payment contributions to your 401(k). The payments you contribute directly from your paycheck, on the other hand, vest immediately.
How much should you put in to your 401(k)?
The best rule about 401(k)s is that you should put in as much as possible. At the very least, invest enough to get the full matching amount that your company pays to match your contributions; otherwise you’re leaving free cash on the table. As you age, you should take advantage of additional catch-up contributions.
Most plans offer matching funds, with the most popular being 3 percent of your salary, according to the Profit Sharing/401k Council of America. Some employers match as much as 6 percent of your salary.
Keep in mind that the IRS mandates contribution limits for 401(k) plans. For example, according to the IRS, here are the limits for the past few years:
|Tax Year 2017||Tax Year 2016||Tax Year 2015||Tax Year 2014|
|Elective Deferral Limit||$18,000||$1,800||$18,000||$17,500|
|Overall Contribution Limit||$54,000||$53,000||$53,000||$52,000|
Data Source: IRS
What are the 2017 contribution limits?
For the 2017 tax year, 401(k) participants can choose to have up to $18,000 of their compensation placed into their account, with an additional $6,000 catch-up contribution allowed for participants 50 and older. These limits haven’t changed for the past two years.
However, the overall 401(k) contribution limits have increased for 2017. Including your elective deferrals, as well as any employer matching contributions, non-elective employee contributions, and any allocations of forfeitures, the overall 401(k) contribution limit is $54,000. For participants 50 or older, the $6,000 catch-up allowance applies to this limit as well, translating to an overall limit of $60,000. You also can’t contribute more than your total compensation.
Why do you want to increase your 401(k) contributions?
Surprisingly, when kids leave home, empty-nesters typically only increase their 401(k) saving by less than 1 percent of pay, a recent Boston College study found. That may not be enough savings to meet your desired retirement goals. Instead of ‘nickel and diming’ those dollars and not saving things, bump up your saving by the amount you had been spending on tuition and room and board. The rules on catch-up contributions to retirement accounts can help. Starting at age 50, you can do the following:
- Add an extra $6,000 a year to a 401(k), up to a $24,000 maximum
- Put an extra $1,000, for a total of $6,500 a year into your IRA
While it may not be practical for you to contribute the maximum, you’ll be surprised how much a small increase can make over time. If you’d like to contribute more to your 401(k) but don’t think you can afford to contribute as much as you’d like right away, here are a few options:
- Increase your contributions gradually.
- Increase your contribution rate by 1 percent of your salary each year until you reach your desired savings rate. For example, if you’d like to defer 10% of your salary into your 401(k) and currently contribute 5 percent, try increasing your rate to 6 percent in 2017, 7 percent in 2018, and so on, until you reach your desired savings rate of 10 percent.
- Increase your contribution rate whenever you get a raise.
- If you get a 3 percent raise this year and increase your savings rate by 1 percent, your paychecks will still increase, and your retirement savings will grow faster.
- Examine the fees you’re paying on your 401(k) investments and see if there may be cheaper alternatives that will achieve the same objectives.
- You can find your fees listed as the expense ratio in your 401(k)’s literature, and generally speaking, lower is better within the same type of investment class.
What 401(k) strategy makes the most sense for you?
The best thing you can do to save for retirement is to contribute as much as you’re comfortable contributing to your 401(k), as early as possible. Your money will never have as much long-term compounding power as it does right now, so take advantage and consider increasing your retirement savings rate as soon as possible.
An expert financial advisor can help you determine what investment strategy may work best for your unique situation.