One of the most frequent questions we get as financial advisors is which type of 401(k) plan should I choose, how much should I contribute, and how should I invest the contributions. While each plan is unique, let’s explore the basics:
- Traditional 401(k) – these are funded with pre-tax contributions, that are deducted from your taxable income, and the distributions are taxed at your ordinary income tax rate during retirement. For example, if you made $100k during the year and fully fund your 401(k) in 2022, your taxable income would be $79,500 ($100k – $20.5k), not taking into account other deductions.
- Roth 401(k) – conversely, these are funded with after-tax contributions and are completely tax free when you take distributions during retirement (after 59 ½). You don’t get any tax break now, but during retirement this can provide a steady stream of tax-free money.
Deciding which type of 401(k) depends entirely on your own situation. The rule of thumb is what is your objective.
Are you currently a high earner trying to limit your tax liability? Then a traditional 401(k) makes sense to take advantage of the tax deduction now. Also, if you are worried about paying the taxes during your retirement years, just keep in mind that your taxable income is generally much lower than you would expect in retirement due to social security income and qualified dividends.
If you aren’t sure what the tax rates might be in the future, and you don’t necessarily need the tax deduction now, then a Roth 401(k) could make sense for you. The idea of tax-free money in retirement is desired by many employees. Also, there is no salary limit to contribute to a Roth 401k, unlike a Roth IRA.
The option of contributing to Roth 401(k)’s continues to gain popularity:
I’m a believer that giving yourself options during retirement is your best bet. Instead of debating whether to do a traditional or Roth 401(k), why not do both?
This allows you to diversify your retirement assets between pretax and after-tax accounts and having options during retirement can be crucial.
The biggest factor when determining your contribution percentage is understanding your employers match. The match will vary by each plan, but some employers will match dollar for dollar up to a maximum of 3%. For example, if I put $10,000 into my 401(k), my employer would put in $3,000. At a minimum, you should be contributing enough into your 401(k) to receive your companies match. It always amazes me that people do not take full advantage of this. WE DO NOT LEAVE FREE MONEY ON THE TABLE!!
A friendly reminder that the employer match is always pre-tax, even if you are contributing to a Roth 401(k).
The nice thing about 401(k) contributions is they are automatically deducted from your paycheck. This allows employees to set it and forget it. Also, contributing to a 401(k) is considered dollar cost averaging as you don’t care if the market is up or down, you will be adding to it regardless (allowing you to capitalize on any market dips).
Most individuals will look at all their options, become slightly overwhelmed, and just put their contributions into the plans default option, which is almost always a target date fund.
Or everyone will look at their investment options, see which funds generated the highest returns last year, and select those funds. Totally rational. Totally moronic.
To be clear, there is nothing wrong with target date funds. These funds help you align your investment risk with your anticipated retirement date. For example, a 2025 target date fund will be roughly 50/50, stocks/bonds. Whereas a 2060 target date fund will be roughly 90/10, stocks to bonds.
However, target date funds don’t know who you are. No investor is the same and everyone has different objectives. If you’re young, you have time on your side and should consider being aggressive with your investments.
- Max contribution for those under 50 is $20,500 for 2022. This does not include the employer match amount.
- If you cash out/take an early withdrawal from your 401(k) (i.e. before 59 ½) you will be subject to a 10% penalty. Learn more here.
- Did you recently get a pay raise? Great! Now increase your 401(k) contribution by at least 1%.
- Making some serious money? Consider taking advantage of after-tax contributions.
- For those that have recently left their employers and have no idea what your options are with your old 401(k), please reach out!
Disclosure: This material is for general information only and is not intended to provide specific advice or recommendations for any individual.