If you are contributing to a 401(k) plan, you probably enjoy seeing your savings grow each year. But that feeling may not be enough to truly protect your account—from you. When you change jobs, and that money suddenly becomes available, you may think of it as an easy way to cover your moving expenses and the other costs of starting your new position. Or you may see your 401(k) as a way to save for a house or another large purchase or as a piggy bank that you may ravage for a child’s education.
But not so fast: Your 401(k) is one of the best options you have to save for retirement, so it’s wise to leave it alone unless you face severe hardship. Not only are there strict rules about withdrawing 401(k) money prematurely, but your 401(k) could be the most valuable piece of your retirement income pie someday; most people do not have any other employer retirement plan. For all of these reasons, your 401(k) is more important than you might think.
If your employer matches your 401(k) contributions, and you don’t contribute enough to receive the full match, you’re missing out on free money.
If you make withdrawals from your 401(k) before age 59½, you generally will need to pay taxes and penalties.
Saving for Retirement With a 401(k)
In the past, many private-sector employees could depend on a traditional, defined-benefit pension from their employer. But that was then. In 1980, nearly 40% of private-sector employees participated in traditional pension plans. By 2019, that number had fallen to less than 15%, and it continues to fall.
Meanwhile, 401(k) plans were growing. Today, they remain a popular choice for investors, as they offer a flexible, proven way to save for retirement. At the end of the second quarter of 2021 (the most recent data available), 66% of all Americans participating in retirement plans were invested in 401(k) plans, which held an estimated $7.3 trillion in assets, according to the Investment Company Institute.
With traditional pensions becoming all but obsolete, increased pressure is on the 401(k) to do the heavy lifting for retirement. Some employees have an individual retirement account (IRA) and other savings to add to the pot, but for most, the bulk of their income likely would come from Social Security plus whatever they have in their 401(k)s.
Social Security and Retirement Income
Even if you take Social Security at your full retirement age—66 for most baby boomers, 67 for workers born in 1960 or later—it will only replace about 40% of your income. Yet financial planners often say you’ll need to replace 70% to 90% of your current income if you aim to maintain the lifestyle you enjoy today. That’s where contributing to a 401(k)—and ideally leaving the money untouched until retirement—comes in.
Withdrawing money from your 401(k) prior to age 59½ usually results in a 10% early withdrawal penalty (there are certain exceptions), and the amount you take out is also subject to income tax. Draining—or even taking relatively modest amounts from—your 401(k) before you retire can have serious consequences for your standard of living in retirement.
Calculating Your Retirement Income
If you are wondering how much income you can expect from your 401(k), the U.S. Department of Labor offers an excellent Lifetime Income Calculator. As an example of how the calculator works, we entered the retirement age of 66 for a person who is currently 46 and therefore has 20 years to go until retirement. We indicated that the employee’s 401(k) contribution was $100 per month and the employer match was also $100 per month, for a total annual contribution of $2,400. We assumed that the individual had been contributing to their 401(k) in previous years and had a current account balance of $50,000.
Based on that information, the Lifetime Income Calculator projected an account balance at retirement of $187,453 and a lifetime income per month of $1,018. If our hypothetical retiree also received the average Social Security benefit of $1,530 (for 2020) and had no other sources of income, their total monthly income would be $2,548. The Social Security Administration also offers calculators that you may use to project your monthly income from that source.
Why Your 401(k) Matters
If you plug your own numbers into the calculation and discover that you won’t have enough retirement income, you’ll need to save more aggressively. That’s where your 401(k) assumes even greater importance, as it can be a much more effective savings tool than an IRA. Why?
In 2021, you can contribute to a 401(k), an annual maximum amount of $19,500 for 2021 and $20,500 for 2022. If you are age 50 or older, you can contribute an extra $6,500 via a catch-up contribution in both 2021 and 2022. However, for an IRA in 2021 and 2022, the annual contribution limit is only $6,000, plus another $1,000 if you are 50 or older.
An advantage of a 401(k) over an IRA is its considerably higher contribution limits.
In addition to the savings cap differential, the other big benefit of maximizing the amount you put into your 401(k) is if your employer matches your contributions by any percentage. If you don’t put in at least enough to get your full employer match, it’s like passing up free money. By the way, that matching money does not count toward your contribution limit.
Benefits of an Employer Match
Many employers match at least a portion of their employees’ 401(k) contributions. For example, let’s say your employer matches 100% of your contributions for as much as 3% of your salary. So if you earn $40,000 per year, your employer’s contribution would add another $1,200 to your 401(k) as long as you contributed at least that much yourself.
If your co-worker earns the same salary and decides not to make a 401(k) contribution, not only do they lose a tax-advantaged opportunity to save for retirement, but have also given up that free $1,200 match from the employer.
A 401(k) match is a terrible thing to waste—as is any 401(k) in general. Too often, though, employees don’t participate in these plans at all. Perhaps they would, though, if they truly understood how they are throwing away free money from the employer match.
The Bottom Line
Always try to contribute at least enough to your 401(k) to get your full employer match. Consider putting away even more if you can afford it, up to your annual contribution limit. If you change jobs, don’t spend the money; Instead, roll it over into an IRA or your new employer’s 401(k), if possible. Either way, your money will continue to grow, tax-deferred, for your retirement years.
Remember that an important key to any retirement savings plan—whatever the type—is to save consistently.