In general, contributing to your 401k plan is a good idea, but there are times where it may not be so good, and there are times where it may make sense to contribute more or less to your 401k plan.
Only Contribute to your 401k Plan If…
You should only contribute to your 401k plan if you have a savings account already that can serve as an emergency fund, and if you have adequate insurance coverage in place such as the appropriate health insurance, property/casualty, and life insurance.
Why should you have these things in place before you contribute to your 401k plan?
401k plans are designed to provide incentives for you to save for retirement, and designed so they are not such an appealing savings vehicle if you need money earlier than retirement. If you lose your job, or a health problem arises, and you must take an early withdrawal from your 401k plan, the taxes and penalties can be hefty. Your 401k contributions are for retirement, not for emergencies, a new car or anything else. Once you have an adequate savings account use additional criteria below to figure out how much to contribute to your 401k plan.
Use Company Match Amount to Determine 401k Contribution Amounts
Find out if your company provides any form of matching contributions to your 401k plan. For example, if you contribute 3% of your income to your 401k plan, they may match these contributions $1 for $1. This provides you an instant 100% return on any 401k contributions you make. Many companies will match your contributions up to a certain percentage of your income. Some companies will make contributions to your 401k plan in the form of profit sharing or non-elective contributions regardless of whether you contribute or not.
Company matching contributions to your account are often subject to a 401k vesting schedule which is a schedule that tells you how much of the money the company put in your account you get to keep if/when you are no longer employed by them. (You always get to keep 100% of the money you contribute to your 401k plan.)
Certain types of contributions, such as something called a “safe harbor match” are always 100% vested, meaning the money is yours even if you terminate employment immediately after they deposit it. Other types of contributions, such as profit sharing contributions, may have a more restrictive vesting schedule which requires you to be employed five years or longer before you get to keep 100% of the money the company contributes on your behalf.
If you don’t plan on working for your employer for very long, and if the company contributions are subject to a lengthy vesting schedule, then matching contributions should not be much of a determining factor when deciding how much to contribute to your 401k plan.
If your company matches contributions, the contributions are subject to a short vesting schedule and/or you plan on working there for awhile, consider contributing enough to receive the full amount of the company match each year.
Consider Taxes When Determining How Much to Contribute to Your 401k Plan
Traditional 401k plans allow you to make pre-tax contributions. Some plans allow you to make after-tax contributions and many plans are beginning to allow you to make ROTH contributions. Each type of contribution has its own tax treatment.
Pre-tax 401k Contributions – pre-tax 401k contributions you make to the plan are not included in your taxable income for the year. When you withdraw the 401k money you will pay income taxes on any amount withdrawn. This type of 401k contribution is best if you are in a higher tax bracket in the years you are making these contributions and expect to be in the same or a lower tax bracket in the years you will withdraw money from the 401k plan. If you have a lot of money already in tax deferred accounts, be sure to read When Tax Deferred Accounts Can Hurt You before deciding if you should contribute even more pre-tax money to your 401k plan.
After-tax 401k Contributions – with after-tax contributions you do not get a deduction to the contributions to the plan, but the money will grow tax-deferred. After-tax 401k contributions are very similar to non-deductible IRA contributions. At the time you withdraw these contributions, you will be taxed only on any gain, You have already paid income tax on the amount of the contributions themselves, so you will not pay income taxes on this amount when you withdraw it. Only some 401k plans allow after-tax 401k contributions.
ROTH 401k Contributions – with a ROTH 401k contribution the money goes in after-tax, and it grows tax-free. Having money in ROTH accounts can be very advantageous to you when you are in retirement, as money withdrawn from your ROTH is not taxable, and it is not included in the formula that determines how much of your Social Security income will be taxable. ROTH contributions are best when you may be in a low tax bracket in the year you make the contributions and expect you might be in a higher tax bracket later when you take withdrawals. ROTH 401k contributions are also an attractive choice if you have a long time to let the money grow tax-free, or if you already have substantial pre-tax savings and need to build up more money in after-tax accounts.
Depending on your tax bracket, it may make sense to make some pre-tax 401k contributions and some ROTH 401k contributions. Good tax planning can make a significant difference in helping you decide what is appropriate for you.
Also, if your income varies from year to year, it may make sense to vary how you save from year to year. With one real estate agent client, in high income years we had her make pre-tax 401k contributions and in low income years she made ROTH contributions.
401k Contributions for Self-Employed Persons
If you are self-employed or if you and your spouse own a business in which you have no employees, you can set up a simplified version of a 401k plan that requires very little administration. See 4 Best Retirement Plans for Self-Employeds for additional details.
The bottom line is saving money is good, and having money saved will open up opportunities for you in the future. So save as much as you can, but do analysis to determine how much of your total savings should go into your 401k plan verses into after-tax savings accounts.