If your employer offers a 401(k) plan, taking advantage of the potential savings this retirement account offers can have lasting benefits. These plans provide a chance to set aside funds that can be deducted from your taxes each year and build earnings over time.
“If you’ve ever dreamed about becoming a millionaire, consider increasing your 401(k) contributions,” says Michael J. Herzog, a tax attorney with Eckert Seamans’ Tax Group, a national law firm based in Pittsburgh.
In 2020, the IRS allows you to contribute up to $19,500 to a 401(k) plan. If you’re 50 or older, you can contribute an additional $6,500 for a total of $26,000.
Here’s what you should think about before increasing your 401(k) contributions:
- Consider how much you can set aside each year.
- Account for other short-term goals you have.
- Make the most of any employer matches available.
- Be aware of additional ways to save.
Use the following criteria to decipher when to boost your 401(k) contributions and how to save more if you can.
Pay Down High Interest Debt
If you’re carrying debt, such as a car loan or credit card, take some time to look at the interest rates linked to the loan or balance. If you have debt with a higher interest rate than the rate of return on the 401(k), you could lose money. For instance, say you have a credit card balance of $10,000 and you are paying an 18% interest rate on it. If your 401(k) plan generally provides a 6% return on the amount invested, you could be paying more in interest on the credit card than you are earning through the 401(k) plan. “You may want to consider paying down your debt before adding to your 401(k),” says Stacey Chin, a wealth advisor with Garrison Point Advisors in the San Francisco Bay area. Once the debt is paid off, you could redirect the amount you spent each month paying off the debt to the 401(k) account.
Create an Emergency Fund
When you invest in a 401(k), the funds can’t be taken out right away for free. If you withdraw funds early, you may have to pay penalties. Rather than putting all your savings in the 401(k) plan, consider setting up an additional savings account you can access easily if needed. “You might be cash-strapped if you put all of your savings into your 401(k) contributions and have an emergency,” says Dillon Ferguson, a certified financial planner and head of product at Zoe Financial in New York.
When setting up an emergency fund, think through the basic expenses you have from month to month. This might include a mortgage or rent payment, transportation costs, groceries and utilities. You can then place funds in the account to help cover these needs if the unexpected happens, like a job loss or medical emergency. The exact amount you’ll want in the fund will depend on your situation. If you’re single, you might want enough saved up to cover three months of living expenses. If you’re married with children, you may feel more comfortable with funds set aside to cover six months of basic expenses.
Get an Employer Match
Some employers offer a 401(k) match, meaning the company will match the amount you contribute, or a percentage of the amount you deposit, up to a certain amount. Ask what the available match is at your workplace. If there is a match available, “Try to contribute at least the max that will get you a match,” Chin says. “Otherwise you’re leaving ‘free money’ on the table.”
For example, perhaps your employer might offer to put in 50% of what you contribute, up to 5% of your salary. If you make $50,000 a year and put 5% of that in the 401(k) plan, you’ll contribute $2,500. Your employer will contribute 50%, or $1,250. In all, you’ll have $3,750 in your 401(k) account.
Balance Other Savings Goals
In addition to saving for retirement, you may have other short-term goals. Perhaps you want an account for an upcoming vacation, anniversary gift or home furnishings. Your family could also be looking to purchase a home, buy another vehicle or make a renovation. You might opt to put some funds in a 401(k) and other money toward upcoming goals.
If you’re contributing to a 401(k) and still have decades left before retirement, “Look to contribute an amount that doesn’t feel like too much of a burden,” Chin says. “If the amount you contribute feels like more than you can afford, you’re less likely to want to increase your contributions in the future when an increased salary means you can.”
You might start putting an amount in a 401(k) that is less than the maximum allowed to have enough to put toward other goals. Over time, you can look for ways to increase the amount you save. Eventually one of your goals might include putting aside the maximum amount allowed each year.
Where to Save After Maxing Out a 401(k)
If you are able to max out your 401(k) and have additional funds to set aside, there are several places the money can be directed. You can check with your employer to see if there are any other retirement plans available for workers. “Your employer might offer a pension plan in addition to your 401(k) plan, which would permit even more retirement savings,” Herzog says.
You can also open or contribute to a traditional individual retirement account or a Roth IRA. With a traditional IRA, the amount you contribute can be deducted from your income at tax time, provided your income is below a certain level. When you withdraw funds in retirement, the earnings will be subject to taxable income. For a Roth IRA, the contributions are made with after-tax dollars, but when you take out funds in retirement, you won’t need to pay taxes on the amount withdrawn. The total amount you can set aside in all your IRAs cannot exceed $6,000 in 2020. If you are 50 or older, the limit increases to $7,000.
Another savings option is a health saving account, which may be available if you have a high-deductible health plan. “HSAs can often be invested and grow tax-free if they’re used for qualified expenses,” Chin says.
For additional savings, you’ll want to think about the varying risk of different types of investments. “Municipal bonds are low-risk, liquid investments,” Herzog says. This means the bonds can easily be sold, and the interest gained on the bonds is not taxed at a federal level. Depending on where you live, the interest might also be exempt from state and local taxes. Higher-risk investments include real estate, individual stocks and exchange-traded funds. Lower-risk options include bonds, savings accounts and CDs.
By Rachel Hartman | US News