How to Know If You Should Invest In Your 401(K)? And How Much?
You just started your first job and your company offers a 401(k) retirement savings plan. If you want to know if you should invest in your 401(k) and how much, I walk you through my decision making process whenever I have tackled this decision in the past.
Cutting to the chase, a 401(k) should be only one part of your overall savings plan. There is no right answer for all people, although if your company matches your contributions, you almost certainly should invest in your 401(k) to at least get the match.
First of All, What is a 401(K) Plan?
A 401(k) is a retirement plan offered through an employer. If you join the 401(k) plan, you are able to contribute money from each paycheck to the savings plan. Any contributions to the 401(k) plan are made before taxes come out of your paycheck. In other words, any money contributed to your 401(k) will reduce the amount of income you make so you pay less taxes. For example, if you pay 25% in taxes and contribute $100 to a 401(k), it would only cost you $75 from your take home pay. Of course, the IRS does not give out free lunch. You will have to pay taxes on the money as you withdraw it after you retire.
Always enroll in your plan as soon as possible, even if you set your contribution to 0%. Many plans have limited enrollment windows and you do not want to have to wait an entire year to enroll. Generally once you are enrolled, you can change your contribution amount at any time and make an informed decision about how much, or if, you want to invest.
Should you contribute to your 401(K)?
Whether or not you should contribute to your 401(K) is not the right question to ask. The proper question is how much should you save for retirement and for your future. Good wisdom says you should save around 20% of your income. Some people say that you should save less than this and some encourage saving even more (like the Financial Independence Retire Early movement also called FIRE). Your savings can be divided between different types of investment and savings accounts. Retirement accounts come with tax benefits but come with withdrawal restrictions. Standard investment accounts come with fewer tax advantages but can be accessed anytime. For retirement plans, 401(K) savings plans and Traditional IRA accounts defer taxes until retirement. In contrast, the Roth IRA require that you pay taxes now and then they grow tax free until withdrawn in retirement.
Of course, if you have credit card debt, you should probably dedicate this 20% to first paying off your debt. The one exception to this is contributing the amount required to obtain a 401(k) match. Never turn down free money.
Never turn down free moneyKelton Johnson (I definitely was the first person to ever say this)
Knowing that we can spread the 20% between different types of savings accounts, we need to decide where to invest. If you cannot start with 20%, start with whatever you afford to save. Then follow the steps below to help you decide where to put your savings. I will run through how much I would contribute to each type of savings account if I made $50,000 annually (the median income in the United States).
Step 1: Does your 401(K) have an employer match?
An employer match is when you the employer matches all or a portion of your contribution up to a limit. One common match is a full 4% match, meaning if you put in 4% of your income, so does your employer. If your employer offers a match, you should always take advantage of the match. Contribute at least the maximum amount required to get the match. In the case of the 4% full match, you would then want to contribute at least 4% to your 401(K) to take advantage of the full match.
Never turn down free money.
Example: Contribution of 4% out of 50,000, or $2,000. Employer will contribute another $2,000.
Step 2: Do you qualify for a traditional IRA or a Roth IRA?
Traditional IRAs and Roth IRAs tend to allow you better access to lower cost investments. For example, your 401(K) plan may require you to invest in mutual funds which charge over a 1% annual fee while in an IRA you can buy any product you want, including a Zero fee Fidelity mutual fund or an ultra low cost fund from Vanguard, Schwab, State Street, or iShares.
You can only contribute $6000 in 2019 to an IRA. If your income is greater than $64,000, you should not contribute to a Traditional IRA because you lose the tax advantage. If your income is greater than $122,000, you cannot contribute to a Roth IRA.
Generally, you should put money in both types of IRA so that you can enjoy the benefits of both a tax deferred Traditional IRA (to reduce taxes today) and a tax-free growth Roth IRA (to reduce taxes at retirement).
Example: I would save $3000 each in a Roth and a Traditional IRA. This is a total of 12% annual income. At this point, you still need to save an additional 4% to reach the 20% savings goal. You could choose to count the employer match toward this 4%, but I am a firm believer that being a more aggressive saver will allow you to more easily reach your goals.
Step 3: Invest the rest in a taxable account or increase the contribution to your 401(K)
At this point, you might need to contribute an additional amount to reach your 20% goal. First of all, you can only contribute $19,000 yourself each year to a 401(k). Your contribution combined with the employer match cannot be greater than $56,000. If you are over those limits, you must instead contribute to a taxable savings or investment account.
The next consideration is whether or not your 401(K) has good products to invest in. If your 401(k) includes index funds with combined expense ratios and plan fees under 0.75% annually, then it is at least a decent plan and you should feel free to invest in it.
You also should consider if you want to lock up your money in a retirement account or not. I suggest saving at least a portion in a taxable account for the sake of flexibility.
Example: I would save $2,000 in a taxable savings account. Now a total of 20% is saved, with the bonus employer match on top.
Should You Invest in Your 401(k)?
In conclusion, you should invest in your 401(k) unless it is a poor plan without a match and with high fees. Instead of focusing on your 401(k), focus on how much you are saving altogether to make sure that you are saving close to or above the 20% number. There is nothing wrong with saving a decent portion in more flexible taxable accounts.
I recommend opening your investment accounts with Fidelity, Schwab, or Vanguard. For retirement planning, I also like Betterment, although they do charge a management fee of 0.25%. I wrote about several of these providers when discussing my 2018 Investment Portfolio.