LAST REVIEWED Jun 11 2020 7 MIN READ
401(k) plans are common tax-advantaged retirement plans offered by for-profit companies in the United States to their employees. 401(k)s are governed by complex rules, but most employers simplify things through their administration of the plan. They offer a limited number of investment options from which you can choose your investment portfolio. The primary advantage of 401(k)s is that they allow you to invest up to $22,500 in 2023 ($20,500 in 2022) of pre-tax income, therefore reducing your total taxable income. However, you invest in the market through your 401(k), so there is some element of risk.
The Four Levels of Retirement Savings
There are four general “levels” of saving for retirement. Reaching the fourth level is the best way to meet your retirement goals. The levels are:
Maxing out your employer match portion of your 401(k) to get all of the available free money
Setting aside six months of living expenses as an emergency fund
Maxing out your Roth IRA to the $6,500 annual cap ($7,500 if you're age 50 or older)
Maxing out the remainder of your employer-sponsored 401(k)
There are multiple variations of this core strategy, but reaching these levels will help you organize and fulfill your retirement planning goals.
The maximum elective deferral for 401(k)s is $22,500 in 2023. This same contribution cap applies to 403(b) plans, most 457 plans, and the federal Thrift Savings Plan. If you are 50 years old or older, you can contribute $30,000 in 2023 — an additional $7,5000 over younger employees.
The Ideal Amount to Set Aside
Your ideal contribution amount should incorporate your retirement goals, your lifestyle, and your family decisions. However, a common rule of thumb is to invest at least 10% of your gross earnings.
If your company offers a matching contribution, another strategy is to contribute at least enough to reach the maximum employer contribution. Doing so will ensure you don’t leave free money on the table, and you can always adjust your 401(k) contributions throughout the year. Before you create a definite plan, confirm whether your employer offers a matching program, and plan accordingly. Many employers match to some degree to 6% of your annual income.
Your 401(k) Investing Rules of Thumb
Some short rules of thumb include:
Prioritizing employer-matched contributions, even over paying down high-interest debts
Carefully choosing between investing in a traditional IRA versus a Roth IRA depending on your current income tax bracket
Increasing your contribution percentage as you age, especially if you’re starting to save later in life
Investing in low-risk options
Think About How Much You’ll Need in Retirement
There are a lot of factors you should consider when planning out how much money you will need during your retirement. These factors include:
If you plan on being married
If your spouse will be employed
Expected income from Social Security and other benefits programs
Potential health concerns
You can also consider how much expected contributions will add up to in the future. For example, contributing $19,000 a year for the next 35 years can generate a nest egg of approximately $2.4 million if the market has a 6% return rate. That may not be enough money, or it may be too much. Either way, it’s important to consider what you anticipate needing in the future to make the best financial choices now.
It’s still possible to save up a significant nest egg later in life. While there is less time for compound interest to bolster your funds, the IRS allows individuals 50 years old and older to make catch-up contributions. The catch-up contribution limit is $7,500 in 2023 and $6,500 in 2022. Experts like Dave Rowan, a Rowan Financial financial advisor, suggest making larger contributions if you’re starting to save later in life. Increasing your 10% savings rate to 20% or more can help you catch up.
401(k), IRA, and Roth: Know the Tax Impact
You would contribute pre-tax dollars to a 401(k) and a traditional IRA — that is, you wouldn’t pay taxes on the contribution amount now, but you will when you withdraw it in retirement. If you contribute to a Roth IRA, you pay taxes on the contribution now but you withdraw it tax-free later. Money from a Roth IRA is more valuable when you’re retired because you don’t have to pay taxes on it.
You can also invest in both account types: once you max out your employer-sponsored 401(k), you can open either a traditional or a Roth IRA. Investing in both a 401(k) and a Roth IRA up to their respective caps of $22,500 and $6,500 ($30,000 and $7,500 if you're age 50 or older) give you access to tax savings both now and in retirement.
Planning for Retirement: The Bottom Line
The earlier you can start saving for retirement, the easier it is because you can make smaller contributions and still stay on track. The optimal retirement strategy is to make the maximum contributions you can early and often. Taking advantage of your employer’s matching programs, opening additional tax-advantaged retirement accounts, and planning ahead are all strong strategies. If you want help managing your retirement plans, consider working with a fee-only financial advisor.
Human Interest can help employers create the right plans and retirement programs to help their employees save for a retirement with a high quality of life. We can help your company manage its 401(k) plan and provide excellent resources for your employees. Contact us today or learn more about how our services work.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.