It’s no secret that saving for retirement is important, and one of the best places to stash those savings is your employer’s 401(k) plan. These plans offer much higher contribution limits than individual retirement accounts, known as IRAs, and can offer lower cost investments thanks to economies of scale. They’re also easy to automate so you don’t have to keep “save for retirement” on your weekly to-do list.
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Plan offerings differ from employer to employer, but the basic way the plans operate are similar. Given how vital these plans are for retirement, you should know a few facts about 401(k)s if you plan to use one — and hopefully you do!
— It’s long-term.
— You may qualify for a tax credit for contributing.
— Understand the fees.
— Autopilot isn’t always the best strategy.
— Consider a Roth 401(k).
It’s Long-term
“Your 401(k) is ‘rest of your life’ money,” says Stuart Sprenger, a senior wealth advisor with Citi Personal Wealth Management. “Its purpose is to take care of you all the way through retirement, and it needs to produce earnings, grow and generate an increasing income for the entire time period.”
This is no small task to accomplish and often requires a careful balance of investment styles. You don’t want to be too aggressive during your working years then suddenly flip a switch to more safer options when you retire, he says. But neither can you afford to be too conservative early on.
“Like most things in life, it all comes down to balance,” Sprenger says. “Most investors should continue to invest in large-company growth stocks, dividend stocks and other potential inflation fighters throughout their lifetime with a significant portion of their retirement assets.”
Of course, the exact mix will depend on your personal situation, “but the common enemy of inflation should still be a focus,” he says.
For your 401(k) to achieve its long-term objectives, it also needs time to work. This means you shouldn’t let the news or current events scare you into changing your course.
“Often when we hear about a hot stock or sector, we break away from long-term goals and switch our investments,” says Mike Lynch, managing director of applied insights at Hartford Funds. “The same can be said when we hear negative things about the market (and) feel compelled to scale back and become extremely conservative.”
The key to successful long-term investing is having a plan and sticking with it. If you aren’t sure your plan is up to the task, this may be the time to speak to a financial advisor or someone at your company’s benefits department for guidance.
You May Qualify for a Tax Credit for Contributing
Employer-sponsored retirement plans offer heaps of tax benefits, but one doesn’t get the press it deserves. It’s called the Retirement Savings Contributions Credit, or more colloquially, the Saver’s Credit.
“This tax credit is designed to help low- to middle-income earners who make retirement contributions,” Sprenger says.
If you are age 18 or older, not claimed as a dependent on someone else’s tax return or a student, and contributed to a 401(k) or other qualifying retirement plan, you may be able to claim a tax credit that will reduce your taxable income for a percentage of your contribution provided your adjusted gross income is below certain IRS thresholds.
In 2024, you must earn no more than $38,250 as a single filer ($76,500 if married filing jointly or $57,375 for heads of household filers) to qualify for the Saver’s Credit.
The credit only applies to a maximum $2,000 worth of contributions ($4,000 for married filing jointly). Depending on your adjusted gross income, the amount of the credit is 50%, 20% or 10% of your contribution. So the maximum tax credit you can claim is $1,000 ($2,000 for married filing jointly).
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Understand the Fees
Few things are free in life, and unfortunately, your 401(k) isn’t one of them. All plans have fees, but what these fees are and where you can see them varies.
“Some 401(k) plan fees are charged directly to the investor’s account and can be seen and measured in the account activity and on the statement,” Sprenger says. “Other fees and costs may be included in the expense ratios of the underlying investments and may not be visible on the company’s statement or website.”
More obscure fees like expense ratios are still important to evaluate because these costs reduce the rate of return on your investments and can be corrosive over the long term. A mere 0.25% increase in expense ratios could cost a $100,000 portfolio $10,000 over 20 years.
“In some cases, the 401(k) fees may be quite high, and an investor may be better off making contributions above what is eligible for their employer match and put it into a self-directed IRA with a lower fee structure,” Sprenger says.
In either case, the key here is to be aware. Review your 401(k) materials and summary plan description to gain a full understanding of all fees and charges you may incur, he says.
Autopilot Isn’t Always the Best Strategy
While it can be smart to automate as much of your savings as possible so you can reduce the chances of missing an opportunity to stash more cash away, you may want to take a bit more hands-on approach to your 401(k) — at least in the beginning.
“Lots of 401(k) plans have defaults, in particular around default investment and default savings rates,” says David Blanchett, managing director and head of retirement research at PGIM DC Solutions. The default investment is often a target-date fund, which “is typically a great way to invest.” But the default savings rate is usually 6% or less annually, which is well below what you’d want to be saving for a successful retirement, he says.
“I’d recommend targeting a total savings rate, which includes both your deferral rate and all employer contributions, including (your employer) match, to be at least 12% of your pay,” he says. “If you can’t get there right away that’s OK, but try to work (up to) there over time.”
One way to do this is by making incremental increases, such as an additional 1% each year, Lynch says. You likely won’t even notice this small change, and if you do, you can always scale your contributions back again.
He also recommends taking a close look at your spending habits to spot opportunities to redirect even small amounts of money into your retirement plan.
Consider a Roth 401(k)
“Just like investment diversification, tax diversification will continue to be important,” Lynch says. If you’re concerned about tax rates going up in the future or want to have access to tax-free income in retirement, consider making after-tax Roth contributions to a Roth 401(k), if available.
Roth 401(k)s are much like Roth IRAs in that the money you contribute is not tax deductible today, but in exchange you get to withdraw it tax free in retirement.
“The choice between traditional and Roth 401(k)s comes down to understanding and comparing the immediate tax benefit versus the post-retirement tax benefit — and which is best for an investor’s unique needs,” Sprenger says.
Typically, Roth 401(k)s appeal more to younger investors with lower incomes who don’t need the immediate tax break of a traditional 401(k) and can reap the benefits of long-term, tax-free growth in a Roth. Investors with higher incomes or who are near retirement may not find a Roth as beneficial, Sprenger says.
Some companies also offer after-tax contributions for high-income earners, often referred to as a backdoor Roth, says Ross Mannino, Ameriprise private wealth advisor and managing director with Wealth Planning Strategies. You can make nondeductible after-tax contributions even if you’ve already maxed out your traditional or Roth 401(k) contributions for the year. The total contributions just can’t be more than the $69,000 combined limit for employees and employers in 2024.
If you do make after-tax or Roth 401(k) contributions, it’s important to be aware that your employer match contributions will still be pretax, meaning that you will need to pay taxes on that money when you withdraw it in retirement. But this also means that “saving at least a little bit in a Roth is a way to create some tax diversification in your savings,” Blanchett says.
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5 Facts to Know About Your 401(k) originally appeared on usnews.com
