The end of the year is a great time to review your investments. For most Americans, the greatest source of retirement savings is tied up in their 401(K) account. Yet, a survey conducted earlier this year by ValuePenguin found that 63% of Americans do not understand their 401(K) plan. In this article, we’ll tell you three of the most important points for evaluating your 401(K) plan.
Does your 401(k) match?
The number one thing to know is if your 401(K) plan comes with a company match. This is essentially free money so it is hugely important! The way a 401(K) match works is when you contribute to your 401(K) account, your company will match your contributions. The amount that employers match vary from company to company and some companies don’t match at all (boooo!). If you don’t know if your company has a 401(K) matching policy, contact your HR and ask them!
Employers typically match contributions up to a certain limit, or cap. This amount is usually expressed as a dollar amount, a percentage of your salary or a percentage of your own contribution. For example, your contributions could be capped at 6% of your salary. This means that if you contributed 5% of your salary to your 401(K), your employer would match that full 5% contribution. However, if you contributed 8% of your salary to your 401(K), your employer would only match the first 6% in contributions (because 6% is the cap).
What a 401(K) match usually looks like
Nowadays it is pretty rare for an employer to match your contributions dollar for dollar. Rather, employers will often match 25-50% of each dollar you contribute, up to the cap. For example, an employer may match 50% of your contribution up to 6%. In that case, if you contribute 6% of your salary, then your employer will only be matching on 3% of your salary (50% of your 6% contribution). In order to reach the 6% cap, you would actually have to contribute 12% of your salary (50% of 12% is 6%). The table below shows what your 401(k) match contributions could look like based on a $100,000 salary.
Because employer matching is basically free money, it makes sense to contribute enough to max out the match. However, you should only do so if it doesn’t stretch out your finances. As you can see from the example above, a 25% match plan can be very expensive contribution wise. Additionally, you must be mindful of the IRS contribution limits. For 2020 the contribution limit is $19,500 for employees under age 50. Employees 50 years and older can contribute up to $26,000. It is very important you do not go over the IRS contribution limit, otherwise, you may incur tax penalties.
401(K) Contributions lower your income tax
Another major advantage of contributing to your 401(K) is that it automatically lowers your taxable income. So even if your company does not have a generous matching policy, the tax savings can still prove valuable. Someone who makes $100,000 and elects to contribute 15% of their salary to their 401(K) will reduce their taxable income to $85,000. You should pay close attention to the tax rates to see if you are on the border of different brackets. For reference, let’s look at the tax brackets for 2020:
Because the US is a progressive tax system, keeping your income from reaching higher brackets can save you money in tax. For example, an individual who makes $180,000 per year should consider contributing $17,000 to their 401(K). Doing so will move their taxable income from $180,000 to $163,00. That’s meaningful because of the income earned above $163,300 being taxed at 32% versus 24%. The result of staying out of the 32% bracket would be a tax savings of more than $5,000!
Tax savings are always relevant
Even if you’re not on the border of a higher tax bracket, the tax savings from contributing to your 401(K) are still relevant. An individual earning $120,000 who contributes $10,000 to their 401(K) lowers their taxable income to $110,000. The result is a tax savings of more than $2,000! These are just examples, and everyone’s situation is different. But it shows you the potential tax-saving advantages of contributing to your 401(K).
However, be sure to weigh the benefit of tax savings versus the benefit of the extra income in your pocket. When you contribute to your 401(K) that money comes directly out of your paycheck. In other words, you never see it. So you’ll want to have a handle on your total income and tax situation, before figuring out how much to contribute to your 401(K) for the sole purpose of reducing your taxable income.
What are your investment options?
Just like matching policies differ from one company to the next, so too do the actual investment options in your 401(K) plan. The average 401(K) plan offers between 8-12 investment options. These are usually some combination of broader market mutual funds and target-date funds. The quality of these funds also tends to vary dramatically. If your 401(K) plan has Vanguard funds in it, that’s a good sign.
Vanguard is one of the most reputable mutual fund company’s in the business. And if you’re able to buy individual stocks or ETFs at your discretion, your company has adopted a liberal 401(K) plan. The vast majority of 401(K) plans do not allow the purchase of any individual stocks. And mutual funds are still most 401(K) plan’s preferred choice over ETFs when it comes to the investment options.
Weighing the pros and cons
The biggest pro to having a 401(K) is if your company has a matching policy. Any matching policy, no matter how small, should be taken advantage of. So if it is small, consider contributing just enough to take advantage of the match. And if it’s a generous matching policy, that’s an excellent incentive to contribute even more. Beyond the match, you should consider how valuable the tax-saving advantages of contributing to a 401(K) are for your specific financial situation. If you’re looking for ways to lower your taxable income, contributing to your 401(K) helps you do that.
The biggest knock on 401(K) plans is the typical lack of investment options. If having investment flexibility is important to you, then you may want to consider a Traditional IRA (or Roth if you qualify). These accounts will give you thousands of investment options to choose from, so your portfolio can be better aligned with your actual risk profile. In addition, IRAs can be managed by a professional money manager of your choice. Whereas your 401(K) cannot. However, any old 401(K) you have from a previous employer is eligible to be managed by a professional. So if you have an old 401(K), make sure you roll it over to an IRA.
Don’t hesitate to reach out
As the year draws to a close it is a great time to review your 401(K) plan and elections. If you don’t understand your company’s matching plan, ask your HR for a copy of the 401(K) Summary Plan Description. This is a document you have a legal right to, and it will contain a lot of important information regarding your 401(K). Also, your elections are what determines how much money you contribute from each paycheck to your 401(K). These elections are generally made through HR, or on the online portal of your 401(K) provider (where you log in to check your account). We strongly encourage you to contact us if there are any things you want to discuss as it relates to your 401(K) plan.
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