Time to Read: 3 Minutes
Consistently saving into a 401(k) plan during your working years is the foundation of a successful retirement plan. The process is usually quite simple, and an additional benefit can be a 401(k) match offered by an employer, which essentially amounts to free money, once you’ve met the threshold to qualify.
There are some questions that frequently come up however, so we’ve put together a quick read that runs through the basics.
Is a 401(k) the Best Way to Save for Retirement?
Nine times out of ten the answer is yes, but we recommend talking to your financial advisor if you are unsure or have any questions. Money is personal, and in some cases there are other considerations, like paying down debt, for example, to consider before allocating income to your retirement plan.
How Much Can I Contribute to My 401(k)?
For 2021, employees can contribute up to $19,500 a year into their 401(k). Anyone over the age of 50 can make an additional $6,500 “catch-up contribution”. Some employees can contribute more than $19,500 depending on the rules of their 401(k) plan, however these extra contributions do not receive pre-tax or Roth treatment.
How Much Should I Save Into My 401(k)?
If you are able, it is always recommended to max out your 401(k), although some limitations may apply. If that is not feasible, the next best thing is to contribute at least up to your employer’s match. Most companies will automatically match a percentage of their employee’s 401(k) contributions as an added benefit and incentive to save for retirement. If you do not take advantage of this match you are essentially losing out on free money. The more you can save, and the earlier you can save, the larger your retirement nest egg may become.
Is It Better to Contribute to a Traditional 401(K) or a Roth 401(k)?
There is no “one size fits all” answer to this question. Choosing between a traditional 401(k), which means you contribute pre-tax money, versus a Roth 401(k), which takes after-tax money, depends on a variety of factors. First of all, you need to consider the tax bracket you are in today, and what bracket you may be in when you retire. Young investors in low tax brackets who expect to earn more over time should almost certainly save into a Roth in order to pay taxes now at comparatively lower rates than in the future.
Many BWM Financial clients tend to be high earners, so saving into Roth may sound counterintuitive. Why pay more taxes when I already reside in such a high tax bracket? It comes down to the fact that these same people tend to find themselves paying high tax rates in retirement as well. Therefore, a Roth might still make sense because you pay the taxes up front as you contribute, rather than later on when the account value has hopefully grown. Not to mention, tax rates may be higher in the future, so paying them now may be a smart tax hedge.
Taxes do not necessarily tell the whole picture and the answer to where you should save is not always clear cut. For example, people often forget to factor in things like estate planning when they decide where to save. Roth 401(k)s will later become Roth IRAs which do not have Required Minimum Distributions (RMDs). The absence of RMDs will benefit high net worth individuals who will likely not spend down all their retirement assets during their lifetime. This makes Roth 401(k)s potentially a better estate tool then traditional 401(k)s.
At BWM Financial, we help clients determine if they should contribute to Roth, traditional, or perhaps a little of both. It is important to look at tax brackets now and in retirement, where tax brackets may be going in the future, estate situations, whether you expect surplus RMDs in retirement, the amount of pre-tax versus Roth money you have now, the amount of savings you have now, and what other options you have for savings. Reach out to one of our BWM Financial advisors and they can help walk you through these important and highly nuanced decisions.