How Much Should You Contribute to Your 401(k) Plan?
Updated: Oct 26, 2022
Everyone should know the basics of how a 401(k) works in order to maximize the benefits it will provide for them in retirement. Many Americans, especially those who are just starting out in their careers, don’t truly understand what a 401(k) is and thus aren’t able to reap the benefits of their contributions.
Ideally, when saving for your retirement, it is best to contribute 15%-20% of your gross income to your 401(k) plan. Aspen Investment Management Inc is here to help you understand your 401(k) and how much you should be saving towards retirement so you can reach your goals and retire comfortably.
What is a 401(k)? | Is a 401(k) Important?
A 401K is a tax-deferred retirement account that many companies offer their employees which allows employees to take a portion of their paycheck and invest it towards retirement. Some companies offer other incentives to their 401(k) plans such as a 401(k) contribution matching program. Employer matching is when an employer contributes / matches a certain percentage of your contribution to your 401(k).
With a 401(k), you can choose the amount you want to invest into your account, with the average contribution being between 5-10% of your paycheck. No matter the percentage you feel comfortable contributing, compound interest will be working on your side.
Time and compound interest are your best friends when it comes to investing for retirement. The earlier you begin to make contributions to your 401(k) plan, the better. As the old saying goes, “Time IN the markets beats timing the markets.” What this means is, investor success has been historically attributed to being invested over a long period of time, rather than the timing of when they invested their money.
The earliest you can withdraw money from your 401(k) penalty-free is at 59.5 years old. You can withdraw earlier, but it comes with penalties. These penalties are often accompanied by an early withdrawal fee plus paying taxes on the money you withdraw. These situations tend to be costly and should be avoided if possible.
Traditional 401K vs. Roth 401K
There are two types of 401(k) accounts – a Traditional 401(k) and a Roth 401(k). With a Traditional 401(k) your pretax dollars are contributed to the account, which you will pay taxes on in the future when you take distributions from your 401(k). With a Roth 401(k), your after-tax dollars are invested, meaning you will not have to pay taxes once they are withdrawn. A Roth 401(k) is offered by some, but not all employers.
Difference Between 401K and IRA
Something that often confuses individuals is that 401(k)s are not the same thing as IRAs. The main difference is that IRAs, or Individual Retirement Accounts, are accounts you set up on your own. As with 401(k)s, there are Traditional IRA(s) and Roth IRA(s). However, whether or not you’re able to contribute to a Roth IRA or take a tax-deduction for Traditional IRA contributions is subject to an income phaseout limit.
401K Vs Pension
Pensions also differ from 401(k)s. With your 401(k) account, you have some control over your investment decisions such as how to allocate the funds and how much you want to contribute, whereas with a pension you have no control over the account.
Pensions are plans in which companies promise to give their employees a certain percentage of their prior income when they retire. Essentially, a pension is a ‘reward’ for working at a company over a certain period of time. Pensions are rare nowadays.
Are There Contribution Limits?
When it comes to employer contributions and employee contribution limits there are some things to keep in mind when exploring your 401(k) plan in 2022.
While there is no minimum amount that needs to be contributed to a 401(k) plan, there is a 401(k) contribution limit for both employer and employee contributions that fluctuates yearly and by age.
Currently in 2022, workers under the age of 50 can contribute a maximum of 20,500 to their 401(k). Anyone over the age of 50 is eligible for an additional catch up contribution of $6,500 The limit on the total employer and employee contributions for 2022 is $61,000. For individuals over the age of 50, that limit is 67,500.
Roth IRAs and traditional IRAs also have limits. The maximum contributions that can be made yearly to any Roth IRA or traditional IRA cannot be more than $6,000. For individuals over the age of 50 the limit is set at $7,000.
For 2023, the 401(k) contribution limit is being increased to $22,500. The catch-up provision for those over 50 is being increased to $7,500, making the maximum contribution $30,000 for 2023.
Things To Do Before Retirement
There are a variety of routes you can take towards saving for retirement. Read more about saving for retirement in a recent blog post from Aspen Investment Management here.
If you need assistance in planning for your retirement, have questions about where to get started, or have questions about your existing plan, reach out to the investment advisors at Aspen Investment Management Inc today to get started towards your financial goals.