A 401(k) plan is a retirement savings plan sponsored by employers that allows employees to contribute to their retirement savings pre-tax. If you can, you should always max out your 401(k) plan. The 401(k) contribution limit for 2020 is $19,500. This is a $500 increase from the contribution limit in 2019. 401(k) plans have many benefits including tax benefits, employee company match and accelerating funding your retirement. Maxing out your 401(k) every year, or contributing up to the contribution limit, enables you to take full advantage of all of these benefits. Even if you’re not sure how you’ll be able to afford contributing $19,500 to your 401(k) this year there are steps you can take throughout the year to get closer to this goal.
When to Plan Your 401(k) Contributions
The beginning of the year is the best time to plan 401(k) contributions for the year. This way, you can spread out your contributions evenly throughout the year. The amount taken out per paycheck will be consistent that way. However, if you do hit the maximum amount early you’ll get a nice surprise of extra money in your take home pay at the end of the year as well as extra money taken out for taxes. If you wait until later in the year to plan your 401(k) contributions it may not be financially feasible. You’ll have to contribute more per paycheck to hit the max, or you may not earn enough the rest of the year to hit $19,500 in contributions. Don’t forget to check your 401(k) in the summer to ensure your contributions are on track to max out your 401(k) this year.
Make Sure To Always Get the Company 401(k) Match
Does your company automatically enroll you into their 401(k) plan? If not, make sure you sign up! Most companies that offer a 401(k) plan also offer a company match. At minimum, you should always contribute enough to your 401(k) to get the full company match. This is free money! The 401(k) company match is one of the top benefits of a 401(k) plan.
It’s hard when you first graduate college and starting from scratch- all the fees with the first apartment, first furniture buys, starting those student loan payments, etc. You may also have to save for bigger purchases like a house down payment and a car. It’s easy to feel like there is just no money to save for retirement.
Instead, look at how you are spending your money and find a way to contribute enough so you get the full company 401(k) match. After that, there are strategies to increase your contributions without feeling like you now have less money to spend over time.
Increase Your 401(k) Contributions During Raises and Promotions
Every time you get a raise or promotion you could afford to increase your 401(k) contribution more. Most companies have an annual raise cycle and if you’ve set your 401(k) contributions to a percentage of your salary your contributions will automatically increase when you get your raise. This time of year is also a great time to increase the percentage you contribute. You have already learned to live on your previous salary, do you desperately need that increase to buy more stuff? If you get a $5,000 raise you can increase your contributions by $1,000 a year and still have $4,000 of your raise. You won’t miss that last $1,000 while you’re adjusting to the extra $4,000 you are now earning every year. Using the table below, you can take the annual amount and divide it by the amount of paychecks per year to get the amount withheld out of each paycheck.
Increase Your 401(k) Contributions When You Finish Paying A Big Expense
Whether it’s putting down your first down payment, or paying off your last student loan, you now have one less expense. Reallocate what you would have spend on that expense to your 401(k) contributions. You won’t miss having the “extra” money because you didn’t have it before.
Enroll In The 401(k) Annual Increase Program
Some plans offer an annual increase program where you can establish annual increases. It depends on the plan, but at least some Fidelity plans allow 401(k) contributions to increase 1% or more each year automatically. You have the ability to align it to pay increases as well and then just set it and forget it. Automating 401(k) contribution increases is the easiest way to increase your contributions. If you end up needing more cash every paycheck you can always go online to your 401(k) plan provider website and reduce your contributions.
401(k) Tax Benefits
You know contributions to a 401(k) plan is pre-tax, but have you ever done the math as to how much you’re saving in taxes by contributing to your 401(k)? You may think you can’t contribute anymore but don’t forget you’ll also save money on taxes.
If you contribute $19,500 to your 401(k) in 2020 here are the tax savings you can expect with the current federal tax brackets. If you are single and making $62,825 a year (mean salary in the 22% tax bracket) you’ll avoid $4,290 in taxes. When you’re making $62,825 a year as a single filer for every 1% additional of your salary you contribute to your 401(k) you’ll avoid $138 in taxes.
401k Benefits Include Compound Interest
Last, but not least, if you need a little more motivation to max out your 401(k) don’t forget about compound interest. The hardest time to contribute to your 401(k) is when you’re young, as you have a lot of big expenses on the horizon and likely the lowest income you’ll ever have. But, thanks to compounding, the more you save early on the less you’ll need to save later. Take this example from the team at J.P. Morgan Asset Management in their 2014 “Guide to Retirement.” Here, they share how much money you can make from investing $5,000 a year over time depending on when you start.
Don’t forget, a 401(k) is one of several options to save for retirement. After you’ve hit your employee match in your 401(k) plan, start contributing to your Roth IRA account before maxing out your 401(k) in order to fully optimize the tax benefits in your retirement savings strategy.