One of the most popular questions we get is, “how much should I save in my 401(k)?”
Making decisions in your 401k can feel daunting, but with a little guidance, you can take control of one of the most important tools you have for a successful retirement. 401(k)’s are the sort of investment that is out of sight, and out of mind. The contribution is set up to be automatically deducted from your paycheck, and so not something you think about all the time.
401(k)’s can be set up into two different ways – Traditional or Roth. The difference between these two comes down to how they are taxed. A traditional 401(k) allows employees to contribute a portion of their paycheck to their retirement account pre-tax. This means contributions are excluded from the employee’s taxable income and will have their tax bill due at the time you start required minimum distributions (RMDs). In a Roth 401(k), contributions are made post-tax. This means a portion of each contribution is withheld for taxes. When you begin taking required minimum distributions (RMDs) in a Roth account, the distributions are tax free1.
Although no one size fits all, there are a few general rules of thumb that you can follow when deciding how much to contribute to your 401(k). You should make it a goal to be contributing at least the minimum to get your employer match if that is offered. This allows you to take advantage of “free money” from your employer1. Every company is different, so know what your match is and how much you should be contributing to receive that match. As you continue working and your income grows you should plan to increase your contributions until you reach at least 10% - 15%2. You want to contribute enough to make sure you don’t need to go back to work during retirement, but not so much that you are stressed about day-to-day bills during your working years1.
The investment options inside your 401(k), can be hard to navigate. Most plan sponsors (the employer) will have a default option – the Qualified Default Investment Alternative (QDIA). If you do not make any choice, this is where your money will go. Often, the QDIA is a target date fund that aligns with your expected retirement date based on age. Target date funds can be a good tool to utilize if you don’t know much about the different fund choices. However, they might not align with your desired risk level, in which case you can construct a portfolio of other funds.
We encourage our clients to build their 401(k) portfolios the same way you would build any other investment account. Diversify amongst as many asset classes as you can including stock funds, fixed income funds, and some alternative investments such as emerging markets or real estate. As we have discussed in a prior blog, having these categories covered brings down the risk, and can offer more downside protection during a downturn in the market.
No matter what investment choice you make inside the 401k, start contributing as much as you comfortably can now with a plan to increase each year. Contact us today if you have any questions about the ins and outs of 401(k)’s.