People are increasingly on their own when it comes to providing for their retirement. Traditional pensions, handled totally by one’s company, are all but unheard of outside of the civil service or heavily unionized industries today. And the pension’s primary replacement, the 401(k)plan, transfers more and more responsibility (and risk) to individual workers.
So, when it comes to employer-sponsored plans, like 401(k)s, it is vital for workers, savers, and investors—and you should see yourself as all three—to make the most they can out of them.
While there are some differences with other plans, such as 403(b)s, most of this planning advice applies reasonably well across all the major plans in the United States, be they 401(k)s or individual retirement accounts (IRAs).
Always be sure to contribute enough to a 401(k) to qualify for matching contributions from your employer.
Be wary of the underlying costs and fees of the various investments within your retirement plans.
401(k) Contribution Limits
For employees who have the ambition and financial wherewithal to make the most of their 401(k), one of the best ways to begin is working backward. Take your maximum allowable annual contribution, divide it by the number of pay periods in a year, and see where that leaves you.
For 2022, the maximum contribution limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan is increased to $20,500, up from $19,500 in 2021. There’s a catch-up contribution of $6,500 if you’re age 50 or older.
Your employer can contribute to your 401(k), too. For 2022, the combined annual limit (the sum of your own and your company’s contributions) is $61,000, or $67,500 with the catch-up amount—up from $58,000/$64,500 in 2021.
Roth 401(k) vs. 401(k)
Either 401(k) option is an important way to save for retirement. The Roth 401(k) provides taxpayers who earn too much to contribute to a Roth IRA to gain Roth IRA benefits—tax-free distributions, no required minimum distributions in your lifetime. —as that money can later be rolled over into a Roth IRA.
After you retire, you can roll your Roth 401(k) account into a Roth IRA.
Max out Your 401(k)
Can you afford to save the maximum? If so, there is not much more you need to do, apart from making the best investment decisions you can within the plan options. If you cannot afford this amount, whittle it down until you can. Clearly, expenses such as mortgage or rent payments, utilities, and food need to be covered, and it makes little sense to put aside so much that you need to accumulate credit card debt to make it through a month.
Even if you cannot make the maximum contribution, consider supplementing this with any bonuses or profit-sharing payments you receive. Many companies allow you to have these amounts deposited directly into your 401(k). This is a good idea whenever possible—many good intentions have gone awry once a bonus check is in hand.
Above all, try to be consistent. Set a specific per-paycheck amount and do not change it unless you have to. Likewise, do not try to time the market or curtail contributions because the economic or political news seems depressing for a while.
If you can, try to save a minimum of 15% of your gross pay. This amount, coupled with reasonable investment returns on those savings, should be sufficient to supplement Social Security down the line and fund a comfortable retirement.
401(k) Employer Match
Fully exploiting an employer match is one of the most vital strategies in getting the most out of your 401(k) plan. Subject to specific rules and limits, your employer contributes the same amount of money you contribute, or a percentage thereof.
This effectively doubles your retirement savings without decreasing your salary or increasing your tax burden. Many employers match up to 3% of your pay—so try as hard as you can to make at least that amount happen.
Want another reason to max out your employer match? In many cases, employers calculate their costs and base their staffers’ salaries based on full matching. If you don’t take advantage of this, you’re handing back free money.
Some employers elect to match your contributions in company stock. While this is not always as desirable as cash, it shouldn’t dissuade you from maximizing your match. Frequently, that stock can be sold and converted to cash within a reasonably short period and at a reasonable cost.
Required Minimum Distributions (RMDs)
Like some other retirement savings plans, 401(k)s have required minimum distributions (RMDs). At age 72, 401(k) owners must start taking RMDs, whether they need the money or not. The IRS is serious about this: There’s a 50% penalty for failing to withdraw the correct amount.
However, RMDs don’t apply if an employee is still working for the same employer that sponsors the plan. Keep in mind that the funds in a Roth 401(k) can be rolled over to a Roth IRA—which has no required minimum distributions during the owner’s lifetime.
Owners did not have to take RMDs in 2020, following the March 2020 passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which temporarily waived distribution requirements for IRAs and other retirement plans. The Act doesn’t impact Roth IRAs, which don’t require withdrawals until after the owner’s death.
An employer may require a certain number of years of service before its matching contributions belong to the employee. This is called a vesting schedule. In general, there are two types of 401(k) vesting schedules:
Cliff vesting happens when the employee goes from owning 0% of matching contributions to 100% after a certain amount of time.
Graduated vesting is where the employee owns an increasing portion of the matching contributions until they eventually own them all.
The U.S. Department of Labor requires full vesting after six years of service. Still, to get the most out of a 401(k)—and the employer match—it’s essential to understand a plan’s vesting schedule. Otherwise, the company could take back some or all of its matching contributions if an employee leaves before being fully vested.
As part of some employee retirement plans, workers can avail themselves of investment advice from independent professionals. Unfortunately, this advice is rarely free, and you may find that you pay 1% to 2% of your funds to get this help.
Understandably, many workers feel overwhelmed when it comes to calculating their contributions and then investing that money. Still, paying for investment advice is a dicey proposition, mainly when it involves a 401(k) plan, for which investors are given a relatively fixed menu of investment options.
Savers also need to pay careful attention to the costs of the investments they hold within their 401(k). In general, mutual fund expenses have come down over the years, and many fund families offer no-load funds for 401(k) plans as well as low-cost index funds. Of course, it’s essential to compare and contrast the numbers because fees still vary a good deal.
Along similar lines, investors need to be careful with financial savings tools like annuities and target-date funds. Annuities arguably do not have much of a place in tax-sheltered accounts to begin with (a topic for another day). What’s more, their often high expense ratios can eat away at their value over time. Likewise, while target-date funds are popular options in many plans, they often (but not always) charge higher fees than regular funds—without correspondingly better results.
For workers who save some funds in a 401(k) but find they cannot contribute more because they are saddled with expensive debt, there may be a counterintuitive option. Most plans have provisions that allow employees to borrow funds from their accounts. This money comes relatively free of strings (insofar as what the funds can be used for). And it is possible to use it to pay off high-interest loans or credit card balances. This money does not come free, but the good news is that the interest charged is being paid to you.
A 401(k) loan is not a risk-free maneuver. That money has to be repaid on time, or the borrower will incur penalties. Moreover, some workers will find that borrowing from their retirement savings is just a little too convenient, which opens a Pandora’s box of future trouble.
Nevertheless, this can be an effective way to free up more money for savings. It is not for everyone, but borrowing low-cost cash from a 401(k) to repay high-cost credit card debt and ultimately invest even more in the 401(k) can be a prudent choice.
If you do not like how a plan is organized or the investment options on offer, say so. Complaining about a deficient plan can be an effective means of improving your choices (and those of your coworkers).
Keep in mind that many employers choose 401(k) plans on the basis of what is cheapest and most convenient to offer, and they may not even be aware of its deficiencies.
While it is true that many workers do not like to be a squeaky wheel, and some companies are undoubtedly apt to be more responsive than others, doing nothing is a pretty good way to ensure that the plan will not be improved.
Traditional and Roth IRAs
What do you do if you have maxed out your 401(k) or want to save even more by using a well-known investment vehicle? Thankfully, there are many options available to you, including traditional IRAs and Roth IRAs.
You can contribute up to $6,000 to either type of IRA in 2022. If you’re age 50 or older, you can add a $1,000 catch-up contribution. Traditional IRAs and 401(k)s are funded with pre-tax contributions. You get an upfront tax break and pay taxes on withdrawals in retirement. The Roth IRA and Roth 401(k) are funded with after-tax dollars. That means you don’t get an upfront tax break, but qualified distributions in retirement are tax-free.
If you or your spouse is covered by a retirement plan at work—including a 401(k)—you can’t take the full deduction for your traditional IRA contributions. And with Roth IRAs, you can’t contribute if you make too much money.
Annuities and Health Savings Accounts
There are other tax-advantaged ways to save after you have maxed out an IRA and 401(k) account. One option is to consider buying and investing in annuities.
There are many advantages and disadvantages with annuities—they can carry high sales loads, typically have high expenses, and sponsors have continually transferred more risk to the investor. All of that said, money in an annuity can accumulate without year-to-year taxation, and it is a worthwhile option if protecting even more retirement savings from the taxman is essential.
The Bottom Line
Tax-advantaged retirement savings plans are one of the relatively few breaks that the government gives to ordinary workers. Careful saving may not be a gateway to becoming independently wealthy. But it can at least go a long way toward ensuring a more comfortable and pleasant retirement.
Whatever the specifics on offer to you, be it a 401(k), a 403(b), or an IRA, make sure to contribute as much as you can afford and take full advantage of your opportunity to put money away for the future.