The vast majority of American workers are no longer covered by a company pension program but rather a 401(k) plan to which they must make contributions and decide how these funds should be invested.
To fund a 401(k), your company must set up and offer the plan to its employees, unlike an IRA (Individual Retirement Account), where any worker can open his or her own account.
Do You Have Access to a 401(k)?
While most larger employers offer a 401(k) plan, many smaller employers do not. If you’re not sure whether your employer offers a 401(k) plan or if you’re eligible to participate, contact your Human Resources department, or owner of the company.
Are You Taking Advantage of It?
If you have a plan, you should probably take advantage of it for several reasons:
- Many employers "match" your contributions dollar for dollar, up to a certain limit.
- Your contributions are tax-deferred, meaning you won’t pay income tax on your contributions. You will pay income tax upon withdrawal—but ideally this will be when you are retired and when your income and tax rates are potentially lower.
- Automatic 401(k) contributions are part of a disciplined process, which allows your money the best chance to grow over time.
“Invest in the future because that is where you are going to spend the rest of your life.”
— Habeeb Akande
How Much Should I Contribute?
It’s a no-brainer to contribute up to the match, but what about contributions above that amount? That depends on how much you need to be saving for retirement and how good your plan is. Some plans offer extremely low-cost funds and charge minimal administrative fees. Other plans offer high-cost funds and/or have high fees. Ask your Human Resources department to see your plan’s fee disclosure statement. Typical lower-cost plans have fund fees between 0.05% and 0.50% and a reasonable cost for administration. Higher-cost funds can range between 0.50% and 1.50% and/or have high administrative fees.
When Should You Not Contribute to a 401(k)?
Generally speaking, this only makes sense when there is no employer match AND when the costs in your plan are excessively high. Keep in mind that whether you contribute or not, you can still fund an IRA for yourself and your spouse, but you’ll have to establish this account on your own.
It can also make sense to forgo participation in a 401(k) if there is no employer match and you do not pay income taxes. In this case you would not benefit from the tax deferral benefit of the 401(k) plan. But this does not mean you should not save for retirement. Again you should fund an IRA on your own, but make it a Roth IRA.
Why You Should Contribute to an IRA
An IRA is a special tax-favored account where you can invest just like you would in a regular investment account, whether it be in stocks, mutual funds or exchange-traded funds. The benefit of the IRA comes from either receiving an upfront tax deduction if you qualify, or the potential for tax-free withdrawals by using a Roth IRA. I’m constantly surprised by how many people don’t understand that they can fund an IRA in addition to their 401(k) and I advise them of the tax benefits they are missing.
Saving and investing for your future is one of the most important things you can do. I have found that most people will greatly benefit from speaking with a knowledgeable professional to learn more about other saving and investment strategies. Reach out to a CFP® professional to get started.