A 401(k) plan is a tax-advantaged retirement account that many employers offer to their employees. As an employee, you contribute pre-tax money from your paycheck and your employer may offer a match based on how much you contribute. A common match offered by employers is a 50% match up to 6% of your total contribution. Meaning, for every pre-tax dollar you contribute, your employer will match 50 cents of each dollar up to 6% of your total gross salary for the year.
For example, if you earn $100,000 a year and you contribute at least the maximum your employer will match (6%), you will receive a matching contribution of $3,000 because 6% of $100,000 is $6,000 and your employer is contributing half of that (50%) so you will have a total of $9,000 in your account for the year. How did we get $9,000? This is your contribution $6,000 (6% of your annual salary) + $3,000 from your employer (50% of $6,000) = $9,000
The most important thing to do when deciding how much to contribute to your plan is to select at least the maximum that your employer will match. You are leaving free money on the table if you don’t! It’s also important to keep in mind that your employer’s contribution does not count towards the limit you are allowed to contribute. In 2020, the maximum amount you can contribute to your plan is $19,500 if you are under age 50 and $26,000 if you are older than 50.
Every employer offers a different plan and some don’t offer any match at all. The money you contribute to your 401(k) plan is yours to keep, no matter how long your stay at your company or if you ever decide to leave. However, the contributions made by your employer could be subject to a vesting schedule. For example, some employers may not match your contribution until you have worked at the company for at least 2 years. Other companies may begin to match your contribution as soon as you begin working but you may have to forfeit their contribution if you leave before you’ve worked at the company for at least 3 years.
So why should you contribute to your 401(k)? Why is it important? Well, to put it simply, this will be your livelihood when you retire. I know plenty of people my age, and some older, who don’t have any money in their 401(k) plans or only contribute 2-5%. One of the common reasons I hear is that they don’t see the immediate benefit or they’re just not thinking about retirement yet.
It may not be at the top of your mind right now because retirement seems so far away, but what if retirement could be closer? What if you planned to retire from wage-paying work before the age of 40 instead of the average age of 65? You would surely need a more aggressive approach to saving for retirement. You wouldn’t be able to reach Financial Independence at a younger age if you were only saving 2-5% of your paycheck every year. Contributing to your 401(k) plan also lowers your taxable income since the money is subtracted from your paycheck pre-tax so it serves to your benefit both now and in the future.
If you aren’t currently contributing to a 401(k) plan, first start by looking into what your company is offering. As a second step, you may choose to start by contributing at least the maximum your company will match, or perhaps you want to think about your long-term financial goals and make a decision based on that. I started off contributing 5% and eventually, I increased it to the maximum yearly limit – this was a gradual move and I didn’t intend to contribute this much when I first started working. This strategy aligned with my long-term goals, so it’s important to consider what your goals are and make your savings decision based on this.