A 401(k) is a great way to save for retirement while also getting the added benefit of receiving employer contributions. Employees can choose to automatically deposit money from their paycheck into their 401(k) plans, and employers can match some or all of the money.
A 401(k) plan is a tax-advantaged retirement plan offered by employers to employees. By investing in a retirement plan like a 401(k), you outpace inflation and earn money at the same time.
In this article, we will discuss the two most common types of 401(k) plans and how much you should contribute to them.
Two Common 401(k) Plans
Two of the most common 401(k) plans are the traditional plan and the Roth plan. The traditional 401(k) plan is a retirement plan that is not taxed until you withdraw money once you retire. The traditional plan is a great way to lower your tax rate for the year because the money you invest in your 401(k) is deducted from your gross income. However, when you withdraw the money when you retire, the IRS taxes that sum amount as income.
The Roth 401(k) plan is taxed at the moment you invest and is counted as income when you deposit. The advantage of this, however, is if in the future when you’re 59 ½ (the eligible age to withdraw without penalty) and your income is higher, it won’t count as taxable income. This means that a Roth 401(k) plan won’t accidentally bump you into a higher tax bracket, which can happen with a traditional 401(k) plan.
Generally, if your salary is in a lower tax bracket than when you retire, you’ll want to opt for a Roth 401(k) plan. However, if you think you’ll be making less than you do now when you retire, go for the traditional.
If you’re not sure, or can benefit from lower taxes this year but don’t want to be taxed when you withdraw for retirement, you can always have a combination of both a traditional 401(k) plan and a Roth 401(k) plan.
Max Out Your 401(k)
If you can go beyond investing 10 percent of your paycheck into your 401(k) plan, you should. A good goal to aim for when investing in your 401(k) is to deposit whatever amount your employer will match. This is essentially free money toward your retirement and can add up to hundreds of thousands, if not millions, of dollars when considering compound interest over time.
The next level of 401(k) investing beyond employer contributions is to max it out to the limit year after year. In 2020, the maximum amount an employee can contribute is $19,500. However, your employer can not only match this but exceed it, either up to 100 percent of your yearly salary or $57,000 – whichever comes first.
Self-Employed 401(k)
If you’re a small business owner, you can take advantage of a solo 401(k) plan to reduce the amount of taxes you have to pay at the end of the year. A solo 401(k) plan allows you to act as both employee and employer – that means you can deposit up to $57,000 per year (or $63,000/year if you’re 50 or older) and not pay taxes on it until you retire and withdraw it.
How Much Should You Save for Retirement
The amount of money you should save for retirement depends on your lifestyle and spending habits. You need to take into account how much you spend every year or budget how much you think you’ll be spending every year when it’s time to retire.
A good rule of thumb to use when determining how much you’ll need to retire is the 4 percent rule, which divides your annual retirement income by 4 percent.
Use this formula: amount needed to live yearly ÷ 0.04
For example, if you think you’ll need $40,000 per year to live, take 40,000 and divide it by 0.04 — this gives you $1,000,000. In other words, to retire on $40,000 per year, you’ll need to have one million dollars in your retirement investment account.
Keep in mind that the 4 percent rule is a rule of thumb and doesn’t account for market crashes or rallies — both things you need to actively monitor to keep your 401(k) healthy during retirement.
Both traditional and Roth 401(k) plans are great investment vehicles that can help you meet your retirement goals faster through employer contributions while beating inflation. If you’re self-employed, a 401(k) plan can also help reduce your taxes because you can contribute as both employee and employer.
Aim to max out your 401(k) and your older self will thank you. Now get out there and start investing.
