When it comes to saving for retirement, you've probably heard that the 401(k) is one of the most valuable and impactful tools you have at your disposal. Here, I'll talk about the 401(k)'s advantages, where it falls short, and how to manage your contributions. Additionally, I'll briefly go over how to evaluate the investment offerings within your 401(k) plan.
Why use a 401(k) at all?
There are two main reasons a 401(k) makes sense for most retirement savers. First, the account offers tax-deferred growth. In other words, by contributing to and investing in a 401(k) plan, you avoid a tax charge today in exchange for the promise to pay tax later. The math works in your favor if you believe your tax rate in retirement will be lower than it is now, when you are working to earn income. Money invested in a 401(k) is yet to be taxed, and as a result, you'll see your investments compound faster. If you start contributing in your 20s, the compounding effect will be magnified as you have more years until retirement.
The second reason to contribute to a 401(k) is the employer match. Most -- but admittedly, not all -- employers offer a matching contribution to your 401(k). If you deposit a certain amount of your gross income in an employer-sponsored plan, it's common for the employer to deposit a "matching" amount, up to a certain percentage of your income. For example, if you're making $100,000 at a company offering a 5% match, the company will contribute $5,000 to your 401(k) annually as long as you make that contribution yourself. If you do nothing else, make sure you contribute to receive your company's full matching contribution.
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OK, I contributed -- now what?
Once you've made the decision to contribute at least up to the employer match, it's time to look at your company's investment offerings. With 401(k)s, investment options tend to differ dramatically with some plans offering mutual funds with extremely high expense ratios. Now that many investment products are essentially free, it's in your best interest to choose one or two broad-market, passive index funds that can be had at a low cost and require minimal maintenance.
For investors just starting out in their careers, a single fund that tracks the S&P 500 or an all-world fund that tracks the whole of global indices is completely acceptable. For near-retirees, you might consider a single total bond market fund that maximizes tax deferral.
Advanced planning considerations
As time goes on, you should begin to view your 401(k) as one of several accounts, or put another way, as one piece of your total financial picture. Once your finances have grown to a level where you're adding accounts outside of your 401(k), you want to place investments with higher income potential -- like bond funds or REITs -- in your tax-deferred accounts. This allows for more seamless tax optimization.
Second, you are able to contribute up to $19,500 to a 401(k) in 2021. This is often far beyond the level at which you'll receive an employer match, but you can still take advantage of additional tax-deferred growth. Contributing up to the annual maximum will also allow for the maximum tax deduction in the current year.
Lastly, a 401(k) is not your only option for retirement savings, so you don't need to view it as an all-or-nothing account. Depending on your income and lifestyle choices, you may not want to lock up large amounts of money in a 401(k) that can't be accessed without penalty until you're 59 1/2. You might also consider looking into a Roth IRA, a nondeductible IRA, or if your income is beyond the allowable limits, a backdoor Roth IRA.
One of many options
While the 401(k) offers many significant benefits, there are some drawbacks that make it less desirable. Nonetheless, if you're working at a company that will match contributions up to a certain level, it definitely makes sense to contribute at least up to that point. Further contributions are a matter of choice: They depend on your flexibility as well as the investment menu offered within the plan. You can't ever really make blanket statements in financial planning, but contributing to your employer plan up to the match is in all likelihood going to work to your benefit.
