Many of us herald this time of year as the arrival of summer, the end of the school year and seemingly longer days with more sunlight. Yet June is also a great time to check in with your employer-sponsored retirement plan.
Are you leaving free money on the table? In addition to offering the potential for free money through a match, employer-sponsored retirement plans can give you significant tax advantages.
Here are four steps to get the most out of your retirement savings.
Understand the Value of an Employer Match
A 401(k) or similar employer-sponsored retirement plan can be a powerful resource for building a secure retirement—and an employer match can add a substantial amount to your nest egg. Let's assume you are 30 years old, make $40,000 and contribute 3 percent of your salary—$1,200—to your 401(k). And, for the sake of this example, let's assume you continue to make the same salary and the same contribution each year until you are 65. After 35 years, you will have contributed $42,000 to your 401(k).
Now let's assume you get a match from your employer. One of the most common matches is a dollar-for-dollar match up to 3 percent of the employee's salary. Taking full advantage of the match literally doubles your savings, even assuming no increase in the value of your investments: Instead of having set aside $42,000 by the time you retire, you will have set aside $84,000, with $42,000 in free contributions. Look at it this way: it's a no-cost way for you to increase your contributions by 100 percent.
In reality though, the impact will be even bigger than that. That's because when you invest money its value compounds. Check out The Time Is Now: The True Value of Time for Young Investors to learn how taking full advantage of a match early in your career can add up.
Recognize the Tax Advantages
In addition to potentially offering free money through a match, employer-sponsored retirement plans can give you significant tax advantages.
Contributions to tax-advantaged retirement accounts, such as a 401(k), are made with pre-tax dollars. That means the money goes into your retirement account before it gets taxed.* Plus, your contributions, any match your employer provides and any earnings in the account (including interest, dividends and capital gains) are all tax-deferred. That means you don't owe any income tax until you withdraw from your account, typically after you retire.
With pre-tax contributions, every dollar you save will reduce your current taxable income by an equal amount, which means you will owe less in income taxes for the year. But your take-home pay will go down by less than a dollar.
Matches and Roth 401(k)s
A growing number of employers offer a Roth 401(k) option, where employees make contributions with after-tax money—and neither the contributions nor any earnings they generate are taxed down the road when the money is withdrawn. While employers can match Roth-directed contributions, IRS rules require that all matched funds reside in a pre-tax account, just like employer-contributed matching funds in a traditional 401(k) account.
As a consequence, the matching funds your employer contributes to your Roth 401(k) (and any earnings on those funds) will be taxed as ordinary income when you withdraw them. If you contribute to both a Roth and a traditional 401(k), the match is applied first to the traditional 401(k) amount and then, if necessary, to any Roth-directed funds.
Play Catch Up
Not all employers provide matches—so if you are uncertain, ask your company's human resources or benefits department. Find out what the maximum percent of salary your company will match—and increase your contribution amount if you find that you are not contributing enough to achieve the full match.
Also be aware that even contributing at the match threshold may not be enough to fund a secure retirement. Most investment professionals recommend a savings level of 10 percent or more of your income annually to generate enough replacement income during retirement to maintain your standard of living—and to start saving at this level as soon as you begin working. Use FINRA's Save the Max calculator to see if you are on track to save the maximum in your 401(k) this year.
The bottom line is that it makes no sense to pass up free money if you don't have to. A company match:
- Increases your retirement savings for free without incurring any risk. Remember: you can, and probably should, contribute more than the match threshold.
- Offers the potential for tax-deferred compounding of that larger sum over time—specifically, your contributions plus the amount of the company's match.
- Reduces the risk of falling short of the savings necessary to fund a secure retirement.
*You pay Social Security (FICA) and Medicare taxes on your 401(k) contributions, but not on any matching employer contributions. See: Retirement Plan FAQs Regarding Contributions—Are Retirement Plan Contributions Subject to Withholding for FICA, Medicare or Federal Income Tax?