A common question that comes up is whether making a higher 401K contribution is worthwhile. Many people wonder, “should I increase my contribution, or keep more money free for the present?”. Allocating your paychecks toward your different liabilities and investments does vary per person, but there are some straightforward rules-of-thumb that can apply universally.
If your employer sponsors your 401K and offers a matching program, the answer to how much to contribute may perplex you. The logic, however, is that for every dollar you have deducted from your pay to apply toward your 401K, your employer will also contribute one dollar, up to a certain percentage of your salary. The exact limit varies from company to company, but the idea is the same.
Although you may be tempted to contribute less so you see a larger amount added to your paycheck each payday, or you may have bills that worry you, or a savings account you’d like to pad, you should consider contributing more.
Why Contribute More to Your Employer’s Matching 401K
There are multiple benefits to leveraging your 401K account. In the context of contribution amounts, up to the match limit your employer enforces, you receive an instant 100% return on your investment. Where else can you get a guaranteed 100% return on your money? This does not even consider the future growth you will see in the long-run (assuming the market is doing well).
You could lose half your account value and still be on top (assuming you are not contributing beyond the match limit). Should you contribute even more? That question is answered on a different basis, but generally yes, if you are under the annual contribution limit ($18,000 for 2015).
A 401K is a tax-advantaged account and is treated differently than a regular brokerage account. Your contributions are taken from your normal pay and reduce your taxable income. Your taxes on that portion of your income is deferred until the time you begin making withdrawals (taxed at the income tax rate you’d then normally be subject to).
In a consumerist society, there is pressure to see gratification from your money now and to spend it sooner. For younger individuals, it may seem offlandish to focus heavily on retirement early. If your income exceeds your expenses enough to live comfortably, however, retirement accounts are often the most logical choice for your extra dollars. In fact, young individuals who get a head start on their retirement allow more time for it to grow, which can make an immense impact in the end value (even just a year or two earlier).
Common Objections & Justifications for 401K Contributions
Remember, if you don’t have other financial goals in the way, and you’re not maximizing your $18,000 401K contribution, you probably are doing yourself a disservice. You don’t have to contribute that much (or anything close to it) to begin seeing the benefits of a matching 401K program. Reassure yourself with the fact you get the instant gratification of doubling your money.
If you’re discouraged by lower paycheck amounts or bank account balances, consider looking at your financial picture from a wider angle: look at the total balance across all of your accounts, or use a tool like the free (and safe) mint.com to help you.
You might be tempted to dabble in stock markets in a traditional taxable account. That is likely not the best choice if you are still under the contribution limit for your 401K, because you’ll be subject to capital gains taxes (unlike 401Ks, where trades do not result in taxes, but instead are triggered by deferred withdrawals). If you are fortunate enough to maximize your 401K contribution and still have left over money to invest, feel free.
Hopefully you can see why not all investment accounts are created equal, and that more traditional uses of money can make less sense (sitting in a savings account will often lead to your money losing value due to inflation). While this discussion did not cover other retirement accounts like IRAs (Roth and Traditional), the unique benefit of employer 401K matching makes for a particularly compelling argument to put your money where it makes the biggest impact.
Next time you think you might miss your money, remember your money is still there. It’s just doubled (and in another account).
Note: Early withdrawals from your 401K are assessed a 10% penalty if they occur before you are 59.5 years old. Saving for retirement is important, but be sure to keep enough money in your savings account to cover any unexpected emergencies – it is best to avoid using your 401K as a piggy bank.