Saving for retirement doesn’t have to be a daunting task. In fact, one of experts’ most-recommended retirement accounts can make saving virtually effortless.
The 401(k) plan is the most common type of employer-sponsored defined contribution plan – i.e. non-pension plan – in the US, according to the Investment Company Institute. About 55 million Americans contribute to a 401(k) plan at work, which allows employees to make automatic deferrals from their paycheck, either as a percentage or dollar amount, directly into an investment account.
From there, employees can choose to invest, most commonly, in a selection of mutual funds, bond funds, index funds, equity funds, and target date funds.
Here are a few of the ways your 401(k) gives you more money than you may realize:
1. Tax deduction
In most 401(k) plans, salary deferrals are not subject to income tax and are treated as a deduction from taxable income. (Roth 401(k)s, which are funded with post-tax salary deferrals, are the exception.)
Say, for example, an employee who earns $60,000 a year elects to defer 10% of their salary to their 401(k). Ten percent of each paycheck will be taken out before income taxes and deposited into their 401(k) account, effectively reducing their taxable income by that amount (up to $19,000 a year).
Since contributions are made pretax, more money goes into the investment account than if the employee were contributing 10% of their after-tax paycheck. Once you reach age 59 and a half, any withdrawals are taxed as regular income, but the real benefit here is the preceding decades of compound growth.
2. Employer matching
Not all types of 401(k)s require an employer to make yearly contributions to employees’ plans, but many do so through matching.
An employer match is free money. To qualify to get the free money, an employee needs to contribute some of their own salary into their 401(k). For example, an employer may promise to match 100% of their employees’ contribution, up to 3% of their salary. If an employee who earns $60,000 contributes 10% of their salary ($6,000), the employer will contribute $1,800 (3% of $60,000) for the year.
Minimally, many financial experts recommend contributing enough money to your 401(k) plan to qualify for your employer match before turning your attention to other tax-advantaged retirement accounts. Talk to the human resources team at your company to find out exactly how your employer’s match is calculated.
3. Over age 50 catch-up contribution
Employees over age 50 can contribute more money to their 401(k) plan than younger employees.
In 2019, the IRS allows employees over 50 to contribute up to $25,000 to a 401(k) – $19,000, plus a $6,000 catch-up deferral.
The SIMPLE 401(k), a similar retirement plan for companies with fewer than 100 employees, allows maximum employee deferrals of $13,000, with an extra $3,000 annual catch-up contribution for folks over 50. By contrast, the over-50 catch-up contribution to an individual retirement account, or IRA, in 2019 is $1,000.