Contributing to a 401(k) plan is a way to help you build savings for your future self and financial security later on in life. One of its benefits is its automation (often deducted straight from your paycheck), and it can make investing easier. It also comes with different tax benefits, depending on the type of plan you elect.
Types of 401(k) Plans
- Traditional 401(k): These contributions are made with pre-tax dollars, which lowers your annual taxable income and grows on a tax-deferred basis. You won’t pay taxes on this money until you begin withdrawing during retirement.
- Roth 401(k): Contributions to this option are deducted after taxes. You pay the tax now, but you won’t be taxed down the line when making withdrawals during retirement.
A good rule of thumb is to opt for the traditional plan if you expect to be in a lower marginal tax bracket during retirement. That way you can take advantage of the immediate tax break. Another consideration is if your budget is extremely tight, the traditional 401(k) doesn’t reduce your immediate spending as much as a Roth will.
If you think you may be in a higher bracket come retirement, the Roth option can help you maximize your savings and avoid higher taxes later on (especially since the Roth can grow over the years and that earned money will be tax-free).
There’s also the option to contribute to both plan types and hedge your bets — just don’t exceed the contribution limits!
2024 Limits
The contribution limits for a 401(k) periodically rise year-over-year due to rising inflation. For 2024, individuals can contribute up to $23,000 to their 401(k) plans, which is a $500 increase from the 2023 limit.
The catch-up contribution limit for employees (aged 50+ years) remains at $7,500, for a total of $30,500. The catch-up contribution helps accelerate the progress for those closer to retirement.
Contributing to a 401(k)
Industry standards suggest saving 12-15% of your income, but it’s important to look at your own financial situation and needs. You don’t want to reduce your take-home pay so much that you end up in a bind and need to withdraw early (before age 59 ½) from your 401(k) — something that comes with a penalty from the IRS.
If your employer offers a company match, make sure you contribute up to the match amount so you’re not leaving free money behind. For example, if your company offers a 3% match, be sure to contribute 3% of your income (which will result in a 6% contribution total).
Another important consideration if you’re participating in your company-sponsored 401(k) is vesting. It’s necessary to understand your company’s vesting schedule so you know what money is yours to keep should you leave your employer. The money you contribute will be 100% yours to keep (or rollover into another employer’s plan), but the contributions made from the employer may take some years before they’re your dollars to keep.
https://www.nerdwallet.com/article/investing/what-is-a-401k
https://www.nerdwallet.com/article/investing/what-is-a-401k
https://www.nerdwallet.com/article/investing/what-is-a-401k
https://www.nerdwallet.com/article/investing/what-is-a-401k
https://www.nerdwallet.com/article/investing/what-is-a-401k