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Now is always the perfect time to evaluate your 401[k] with these four simple questions.
How much should I contribute to the plan?
Contributions to a 401[k] are either employee deferrals (via a paycheck) or employer contributions. Contributions of 15% of your annual salary will significantly impact your ability to comfortably retire. Your employer may match dollar-for-dollar contributions up to a certain percentage, which means your return on your contribution is an immediate 100%. How to start?
- At a minimum, contribute enough to maximize your employer contribution– free money.
- Start with 5% of your salary, and commit to a 1% increase in contributions each year.
How should I make my contributions?
Almost all 401[k]s give participants the option to make Roth or Traditional contributions. The difference between Roth and Traditional contributions?
- Roth — you pay tax on contributions today; the account grows tax-free; and no future taxes are due on the earnings for distributions after age 59.5
- Traditional — defer tax on contributions today; the account grows tax-deferred; and pay taxes on distributions after age 59.5
A traditional 401[k] contribution lowers your current taxable income today. Roth 401[k] contributions don’t lower your taxable income. If you expect to be in a higher tax bracket in the future, a Roth 401[k] may be best because your tax bracket is lower today than you anticipate in the future.
Let’s say you earn $1,000 and decide to defer $100 to your 401[k]. If you were to defer the $100 as a regular/traditional 401[k] contribution, you would be taxed on $900 of your income ($1,000 earning minus $100 contribution) and, in turn, deferring the taxes paid on your retirement account contribution. The funds in your 401[k] would grow tax deferred until you withdraw the funds, at which time your distributions from your 401[k] would be taxed as ordinary income (as a salary would be taxed). On the other hand, if you were to contribute the same 100 as a Roth 401[k] contribution, you would be taxed on $1,000 of your income because Roth accounts pay taxes today. The funds in your Roth 401[k] would grow tax-free until you withdraw the funds, at which time your distributions from your 401[k] would be withdrawn tax-free.
Everyone has a different tax situation and timeline to retirement, which may change the best tax strategy for saving to your 401[k].
How do I invest my money?
When thinking through how to invest your retirement account consider risk tolerance, diversification, and cost. Risk tolerance is your ability to tolerate a decline in the value of your investments.
Diversification is investing in a broad mix of investments to minimize the risk of any one investment performing poorly for an extended period of time. Many plans offer Target-date funds, which can be a good set-it-and-forget-it option for retirement accounts. These funds offer diversified portfolios that
automatically become more conservative over time as retirement approaches.
Low-cost investments are the ones with a lower expense ratio. The lower the expense ratio, the more you keep in your pocket.
Who inherits my 401[k] if I die?
Your will does not control the disposition of your 401[k], your beneficiary designation form does. A beneficiary is a person or entity you designate to receive these retirement funds when you die. Most retirement plans require your spouse to be listed as your beneficiary. You can name whomever you wish, but your spouse will need to provide written agreement if your beneficiary is someone other than your spouse. If no beneficiary is listed, state law determines the recipient of your retirement assets via the probate process. Be sure to keep a copy of this document with your will and other key documents.
If you have questions about your retirement plan, ask your employer for the contact information of the retirement plan advisor.
