There has been a recent push to ditch the 401(k) for its sexier cousin, the Roth IRA. Keep in mind, sexy doesn’t always get the job done. I helped my mom retire after bankruptcy only using her 401(k). Before I get into the top reasons to contribute to your 401(k), what’s a 401(k) plan? A 401(k) is an employer sponsored retirement plan where the employee contributes a portion of their salary and selects their investments from the plan’s investment options. Many of the 401(k) rules also apply to 403(b) and 457 plans.
You are taxed unless Congress says you aren’t
When Congress gives opportunities to defer taxes, it’s usually in your best interest to take it. Tax deferral is arguably the best 401(k) benefit.
The money you contribute to your 401(k) is not subject to federal income tax. Pre-tax contributions provide two benefits. First, contributions reduce your taxable income. Second, you receive the benefit of growth without taxes (tax deferred). In retirement, you control your taxes by only paying taxes on money withdrawn.
A close second to tax deferral is the Roth 401(k), growth and earnings are withdrawn tax-free. Roth 401(k)s have been an option for employers since 2006, but it’s still not offered by many. Unlike the Roth IRA, the Roth 401(k) has no income limits; a huge win for high-income earners.
Additionally, saving money after taxes requires more money than saving on a pre-tax basis. For example, for someone in the 25% tax bracket, an $18,000 pre-tax contribution would be a $13,500 after tax contribution. Finally, it’s difficult to calculate the true value of tax deferral until retirement. Using the above calculation, at a 7% rate of return over ten years:If the retiree’s tax bracket is the same as it was during her working years, it’s a wash between Roth contributions and pre-tax contributions. But if the retiree is in a lower tax bracket in retirement, which is usually the case, deferring taxes provides more money for retirement.
More money for your retirement goals
The main difference between an employer-sponsored plan and IRA (Traditional or Roth) is the increased contribution limits. In 2017, the contribution limit for employer-sponsored plans is $18,000 and an additional $6,000 for “catch up” for employees over 50. Conversely, an individual can only contribute $5,500 with an additional “catch-up” of $1,000 for those over age 50. If you are single and make more than $117,000 ($184,000 for married couples), then your ability to contribute to a Roth IRA diminishes. Luckily, even if an employee makes too much for the Roth IRA, he/she can still take advantage of the Roth 401(k).
No free money for IRAs
Employer contributions to your retirement might seem altruistic but they aren’t. Employers receive a tax deduction for contributions and contributions help recruit and retain employees. Since IRAs are held and managed by an individual, there are no employer contributions.
There are two different types of employer contributions, non-elective and matching. Although you are entitled to non-elective contributions even if you don’t participate in the plan, these are less common than matching. To receive a match, the employee has to contribute to the plan. According to the 56th Annual Profit Sharing and 401(k) survey, 95.3% of 401(k) plans made matching contributions. The most common match calculation is 50% of employee contributions to the first 6% percent of an employee’s salary.
Although there are legitimate concerns about 401(k) fees and limited/poor investment options, neither should stop you from contributing. There are ways to mitigate them, which I will discuss next week. We need all the financial goodness we can get when it comes to retirement. High contribution limits and employer contributions mean more money directed toward your retirement goals. Tax deferral is a tool that can save you money now and during retirement. My suggestion is to contribute to your 401(k) and IRA after figuring out what the best mix is for you.