If you use a 401k properly, it can be a great retirement savings vehicle. With employer matches, automatic deposits, diversified investments and relatively high contribution limits, a good 401k plan almost forces you to do what comes so hard to many Americans — saving and investing.
A 401k is a defined contribution plan, which means that you’re allowed to make contributions as an employee. Check out these nine strategies to make the most of your 401k plan and hone your retirement-planning skills.
You can actually earn free money with a good 401k plan. Many employers will match at least a portion of the money you contribute to your plan, and that money goes right into your 401k — it immediately boosts your account’s value, and you don’t have to pay tax on it.
The first step to take full advantage of this employment benefit is to check the terms of your plan. You’ll want to contribute at least the minimum amount that will qualify you to receive the matching funds. For example, if you earn $ 75,000 and need to contribute at least 5 percent to get the match, you will need to contribute $ 3,750, and then your employer will deposit a matching amount of $ 3,750 into your 401k account. You’ll not only benefit from the additional deposit but also the compound interest accruing on your balance.
Once you determine your contribution amount for your 401k, you can have it automatically deducted from your paycheck. For example, if your paycheck is $ 5,000 and you agree to a 10 percent contribution rate, then you’ll receive $ 4,500 — minus any deductions for taxes or other services. The $ 500 designated contribution will automatically be deposited into your 401k plan. Many employers will automatically enroll employees in a 401k plan as soon as they are eligible, but it’s up to you to adjust your contribution amount or percentage according to your retirement planning needs.
When your money is automatically taken out of your paycheck, you’re less likely to spend it on something else. Meanwhile, that money is growing your retirement savings. Studies have shown that the people who are in the best financial position at retirement are the ones who participated in employer-sponsored retirement plans and opted for automatic contributions.
The best way to maximize your 401k account is to contribute the annual limit. The IRS makes cost-of-living adjustments to 401k contribution limits almost every year, so check for updates. For the 2016 tax year, the 401k contribution limit was $ 18,000 of earned income; the limit is the same for the 2017 tax year. The amount you contribute cannot exceed the amount of your compensation in any one year, so if you earn only $ 12,000, for example, you can’t contribute more than $ 12,000.
The IRS also limits the amount of total contributions you can make to a 401k plan. The total contribution limit includes employer-matching contributions and lesser-used additions, such as employer nonelective contributions and allocations of forfeitures. The total amount you can contribute to your 401k plan in any one year is $ 54,000.
A simple trick to help maximize your 401k savings is to automatically increase your contribution rate every month, quarter or year. If you can increase your contribution by 1 percent every year, you’ll be significantly increasing your contributions over time — and you’ll likely not even notice the increase. For example, say you start saving 6 percent of your $ 40,000 annual salary; that would amount to a weekly contribution of $ 46.15. If you increase that rate by 1 percent a year, your weekly contribution would go from $ 46.15 the first year to $ 53.85 the next year, and so on.
If you start this process when you’re young, by the time you reach your prime earning power, you’ll be saving more than 20 percent of your salary. Incremental increases make saving more much easier than trying to save a large chunk of your paycheck all at once.
Another easy way to boost your 401k plan is to invest your pay raises into your account. If you get a 10 percent raise, consider raising your 401k contribution rate by the same 10 percent — you’ll still be living on the same amount of money you’re used to, but your retirement savings will get an immediate kick. At the very least, consider raising your contribution by a few additional percentage points, which can increase your retirement savings and prevent “lifestyle creep” — the tendency to spend more when you have more.
The same idea applies to bonuses, tax refunds or other money windfalls: It’s money you weren’t counting on to cover your daily expenses. If you add that money into your 401k plan, you’ll be maximizing your retirement savings without impacting your current financial situation.
If you’re 50 or older, you have an opportunity to save even more for your retirement. On top of the 2016 tax year $ 18,000 individual maximum contribution, the IRS allows those who will turn 50 or older by the end of the calendar year to make an additional $ 6,000 in elective contributions.
This catch-up contribution can be essential to saving enough for retirement. Even if you earn a return of 0 percent on your invested funds, adding an additional $ 6,000 per year from the time you turn 50 until you reach retirement age at 65, for example, can result in an additional $ 90,000 in your account. The average 401k balance of someone who makes use of catch-up contributions is $ 417,000 versus $ 157,000 for someone who did not, according to Fidelity Investments.
If you’re already contributing to a traditional 401k plan, you’re likely familiar with the tax benefits. For starters, your contributions are pretax, meaning you don’t have to claim what you contribute as income when you file your taxes. Additionally, the money you put in your 401k grows tax-deferred, meaning you don’t have to pay income tax on it until you withdraw it.
If your employer offers a Roth 401k, you will have a different set of tax benefits. You won’t get to exclude your contributions from your income, meaning you’ll be paying tax on them before you put them in your account. When you take your money out, however, you won’t owe income tax on your earnings or your contributions. If you anticipate being in a higher tax bracket at retirement, the Roth 401k might be a better way to maximize your 401k contributions.
Your 401k might seem like a free investment because you probably don’t pay upfront sales charges to invest in a fund — but your plan carries a cost. Typically, some of the available funds in a 401k plan charge more in investment fees than others. And some funds might charge an upfront commission, which you might not know about unless you review the fee disclosure statement that all 401k plans are required to provide.
The bottom line is that the less you pay in fees, the more you money you can save or invest. Over decades of investing, these fees could shave 25 percent off your total return. Index funds, which invest in defined indexes like the Standard & Poor’s 500 index or the Dow Jones industrial average, typically carry lower costs than more actively managed funds.
If you’re self-employed, you can still participate in a retirement plan by opening a solo 401k. Legally, as long as you have self-employment income, you’re entitled to establish and contribute to a solo 401k plan, which the IRS calls a one-participant 401k plan.
The good news about a solo 401k plan is that as both an employer and an employee, you’re allowed to make both types of contributions. For the 2016 tax year, this means that you can contribute $ 18,000 as an employee — assuming you earn at least $ 18,000 — and up to 25 percent of your compensation as an employer. So, if you earned $ 40,000, you could contribute $ 18,000 as an employee and $ 10,000 as an employee for a total contribution of $ 28,000.
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