Retirement savers, are you making the most of your company's 401(k) match? Even though a quarter of the year has gone by, you can take steps to make the most of your company's 401(k) match. Each year, Americans leave billions of dollars in 401(k) company matches on the table. Here's how to avoid becoming one of the estimated one-in-four employees who miss out on free money.
Continue Reading Below
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 an employee's nest egg. Let's assume you are 30 years old, make $40,000 per year, and contribute 3% of your salary ($1,200) to your 401(k). And, only for the sake of this example, let's also assume you continue to make the same salary and same contribution each year until you are 65. After 35 years, you will have contributed $42,000 to your 401(k).
Image source: Getty Images.
Now let's assume you get a match from your employer. One of the most common matches is a dollar-for-dollar match on up to 3% 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.
That's $42,000 in free money. Looked at another way, it's a no-cost way for you to increase your contributions by 100%.
Continue Reading Below
Recognize the tax advantages
In addition to offering the potential for free money through a match, employer-sponsored retirement plans can give you significant tax advantages. With a traditional 401(k), for instance, your contributions are made with pre-tax dollars -- meaning the money goes into your retirement account before it gets taxed. In addition, 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. Here's how that works. Building on the example above, the $1,200 you contribute to a traditional 401(k) lowers your federal income tax bill for the year because you owe taxes on only $38,800 rather than $40,000. If you're single, your total federal tax bill using the 2017 IRS tax rate schedule is $3,848 instead of $4,028 -- a tax savings of $180.
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 of this rule, 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.
Not all employers provide matches, so if you are uncertain, ask your company's human resources or benefits department. Find out what the maximum percentage 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% or more 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 $18,000 maximum ($24,000 if you are 50 or older) in your 401(k) this year.
The bottom line is that it makes no sense to pass up free money. A company match:
- Works out to a 100% increase in the amount of money you set aside each year that is matched, without incurring any risk -- and remember that 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 plusthe amount of the company's match.
- Reduces the risk of falling short of the savings necessary to fund a secure retirement.
The $16,122 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.