One of the most common employer benefits in our country right now is an employer-sponsored retirement plan. Or, in other words, a 401(k) or something of the sorts. Other types of employer-sponsored retirement plans are 403(b)s and SIMPLE IRAs. Over the past few decades, companies have shifted from defined benefits plans to defined contribution plans and forced the employee to save for his/her own retirement versus the employer. While there are pros and cons of each, it transfers the entire responsibility of saving onto the employee. So, if your employer offers a retirement plan like a 401(k), should you contribute and if so, how much?
First and foremost, determine if your employer offers a match. For example, many employers will match 100% of what you put in up to 3% or 5% of your income. Just sit back and think about this… your employer is willing to give you free money if you put money in your 401(k). Free! That’s a 100% rate of return immediately. Taking advantage of your employer’s match is hands down one of the best ways to save for retirement. I personally have never heard of another investment out there that offers an immediate 100% rate of return like an employer match in a 401(k). Yes, it’s in a tax-deferred account that you can’t touch until you’re at least 59 ½, but it’s still free money.
Before recommending contributing above and beyond your employer’s match, it’s good to know of some benefits you’ll receive from contributing and some stipulations. Some benefits:
- Contributions reduce your taxable income – If you put money into your employer’s 401(k), usually these contributions are pre-tax (they can be after-tax, but we’ll stick to pre-tax for now). This means that you get to deduct your contributions from your income in the year in which you contribute.
- Earnings grow tax deferred – Once you’ve contributed money into your 401(k), as it grows over the years, those earnings in the stock market grow tax deferred. Each year, you don’t get taxed on the money you make. You only get taxed on the money whenever you pull it out of the 401(k).
- Free money – As I’ve already covered, contributing to take advantage of an employer’s match is free money. Simple as that. If you put in 3% and your employer matches 3%, you’ve just doubled your money! Then, both your contributions and your employer’s contribution continues to grow tax deferred for years and years until you pull it out.
But of course, there’s also some stipulations that come with it:
- Locked up until 59 ½ - The government has restrictions on when you can begin pulling money out of your employer-sponsored retirement plan. Currently, this age is set at 59 ½. Once you reach this age, you are no longer penalized for withdrawing money out of your 401(k). So, if you do contribute money to a 401(k), make sure you have the mindset that this money is long term and doesn’t need to be touched until you hit that minimum age.
- Taxed as ordinary income when withdrawals are made – So you got a tax deduction for contributing to your 401(k). You didn’t think the IRS would forget about that, did you? Since you got a deduction for contributing to your 401(k), whenever you pull money out, that’s when you’re taxed. Plus, it’s taxed as ordinary income (just like a W-2 job).
There’s most certainly more pros than cons when it comes to contributing to a 401(k). How much should you contribute above and beyond the employer match? If your bucket 1 is in place, then we’d recommend a general guideline of saving approximately 15% of your income for retirement. However, everyone’s situation is different, and everyone’s retirement goals are different, too. Let us know if we can help walk through how much you should contribute to your employer-sponsored retirement plan. We love helping!