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Updated on Monday, November 18, 2019
You’re probably familiar with the basics of a 401(k). You know that it’s a retirement account, offered by your employer. You know that you can contribute a percentage of your salary, and that you get tax breaks on those contributions. And you may know that your employer might offer matching contributions.
But beyond the basics, you may have some confusion about exactly how your 401(k) works and what you should be doing to maximize its benefits. This guide will tell you everything you need to know so that you maximize your 401(k) contributions.
The 4 types of 401(k) contributions
When it comes to maximizing your 401(k), nothing you do is more important than maximizing your contributions. While most investment advice focuses on how to build the elusive perfect portfolio, the truth is that your savings rate is much more important than the investments you choose.
While it is important to build a balanced portfolio, make sure you don’t neglect the easy stuff like maxing out a 401(k). This is especially true when you’re just starting out.
There are four different ways to contribute to your 401(k), and understanding how each one works will allow you to combine them in the most efficient way possible for your needs. By adding more money, you’ll be inching closer to a financially secure retirement.
1. Employee contributions
Employee contributions are the only type of 401(k) contribution that you have full control over, and they are likely to be the biggest source of your 401(k) funds. That’s because these are the contributions that you make to your 401(k). Employee contributions are typically a percentage of your salary, automatically deducted directly from your paycheck each pay period.
The key here is that it’s up to you to decide what percentage to have deducted—up to a certain amount. In other words, employee contributions are your chance to get the most bang for your buck.
Let’s say that you earn $3,000 every two weeks. If you decide to contribute 5% of your salary to your 401(k). In this case, $150 will be automatically taken out of each paycheck and deposited directly into your 401(k). Automation is the advantage: Everyh week, a percentage of your pay is out of sight and stashed safely away for your golden years.
Maximum personal contributions
The IRS sets limits on how much you can contribute to your 401(k) in a given year. For 2019, employee contributions are capped at $19,000, or $25,000 if you’re age 50 or older. These limits will increase to $19,500 and $26,000, respectively, in 2020. In subsequent sections we’ll talk about how much you should be contributing in order to maximize these contributions.
Traditional 401(k) vs. Roth 401(k) contributions
There are two different types you need to choose from—a traditional 401(k) or a Roth 401(k)—each with a different set of tax benefits:
- Traditional 401(k): Traditional 401(k) contributions are tax-deductible in the year that you make the contribution and grow tax-free while inside the 401(k). They are taxed as ordinary income when you withdraw the money in retirement.
- Roth 401(k): Roth 401(k) contributions are not tax-deductible in the year you make a contribution, but they grow tax-free while inside the account—and you won’t pay taxes when you withdraw the money in retirement.
Both the Roth 401(k) and the traditional 401(k) have the same contribution and catch-up contribution limits, as well as a 10% early withdrawal penalty. The main difference between the two types of plans comes down to taxes, as reflected above.
If you have both options available, how do you choose the right one? It typically comes down to age. If you’re younger and just starting out in your career, the Roth 401(k) makes more sense, as you’re likely in the lowest tax bracket you’ll ever be in and thus you’ll pay lower taxes on contributions. If you’re more advanced in your career, it might make sense to go with a traditional 401(k), because 100% of your contributions are invested, giving them maximum chance to grow.
2. Employer matching contributions
Many employers match your contributions up to a certain point, meaning that they contribute additional money to your 401(k) each time you make a contribution.
Employer matching contributions are only somewhat in your control. You can’t control whether your employer offers a match or the type of match they offer, but you can control how effectively you take advantage of the match they do offer.
Taking full advantage of your employer match is one of the most important parts of maximizing your 401(k). Skip ahead to this section to learn more on how to maximize your employer match.
3. Employer non-matching contributions
Non-matching contributions are contributions that your employer makes to your 401(k) regardless of how much you contribute. Some companies offer this type of contribution in addition to, or in lieu of, regular matching contributions.
For example, your employer might contribute 5% of your salary to your 401(k) no matter if or how much you contribute. Or, your employer might make a variable contribution based on the company’s annual profits.
It’s important to note that these contributions are not within your control. Your employer either makes them or not, no matter what you do.
However, these contributions can certainly affect how much you need to save for retirement, since more money from your employer may mean that you don’t personally have to save as much. Or, these contributions could be viewed as additional free savings that help you reach financial independence even sooner.
4. Non-Roth after-tax contributions
This last type of contribution is rare. Many plans don’t even allow this type of contribution, and even when they do, these contributions are rarely utilized. To find out if your 401(k) plan does allow these contributions—many do not allow them—you can refer to your 401(k)’s summary plan description.
And even if these contributions are allowed, it typically only makes sense to take advantage of them if you’re already maxing out all of the other retirement accounts available to you.
But if you are maxing out those other accounts, you want to save more and your 401(k) allows these contributions, they can be a powerful way to get even more out of your 401(k).
How non-Roth after-tax 401(k) contributions work
Non-Roth after-tax 401(k) contributions are sort of a hybrid between Roth and traditional contributions. They are not tax-deductible, like Roth contributions, which means they are taxed first and then the remaining money is what is contributed to your account. The money grows tax-free while inside the 401(k), but the earnings are taxed as ordinary income when they are withdrawn. The contributions themselves are not taxed again.
Here’s a quick example to illustrate how the taxation works:
- You make $10,000 of non-Roth after-tax contributions to your 401(k). You are not allowed to deduct these contributions for tax purposes.
- Over the years, that $10,000 grows to $15,000 due to investment performance.
- When you withdraw this money, the $10,000 that is due to contributions is not taxed. However, the $5,000 that is due to investment returns — your earnings — is taxed as ordinary income.
The value of non-Roth after-tax 401(k) contributions
This hybrid taxation means that on their own non-Roth after-tax contributions are typically not as effective as either pure traditional or Roth contributions.
However, they can be uniquely valuable in two big ways:
- You can make non-Roth after-tax contributions in addition to the $19,000 annual limit for 2019 on regular employee contributions, giving you the opportunity to save even more money. They are only subject to the $56,000 annual limit in 2019 ($62,000 if eligible for catch-up contributions) that combines all employee and employer contributions made to a 401(k).
- These contributions can be rolled over into a Roth IRA when you leave your company or even while you’re still working there. And once the money is in a Roth IRA, the entire balance, including the earnings, grows completely tax-free. This contribution rollover process has been coined the Mega Backdoor Roth IRA, and it can be an effective way for high-income earners to stash a significant amount of tax-free money for retirement.
How to maximize your 401(k) employer match
Now that you have an understanding of the types of contributions available to you, it’s time to start maximizing them. The first step is making sure you’re taking full advantage of your employer match.
Simply put, your 401(k) employer match is almost always the best investment return available to you. Because with every dollar you contribute up to the full match, you typically get an immediate 25%-100% return.
How a 401(k) employer match works
While every matching program is different, a typical plan offers a partial match or a dollar-for-dollar match. The names clue you into how they work. A partial match means your employer agrees to match a certain percentage of your contributions, up to a specified point. For example, your company could match 50% of your contributions up to 6% of your salary. That means if you contribute 4% of your salary, your employer will contribute 2%.
A dollar-for-dollar match means that your employer has agreed to match 100% of your contributions, up to a specified point. So if you contribute 5% of your income to your 401(k), your employer also contributes 5%. Just like the partial match, anything above the match limit is not matched.
How does this work in the real world? Well, let’s say that you make $3,000 per paycheck and that you contribute 10% of your salary to your 401(k). That means that $300 of your own money is deposited into your 401(k) as an employee contribution each paycheck, and your employer matching contribution breaks down as follows:
- The first 3% of your contribution, or $90 per paycheck, is matched at 100%, meaning that your employer contributes an additional $90 on top of your contribution.
- The next 2% of your contribution, or $60 per paycheck, is matched at 50%, meaning that your employer contributes an additional $30 on top of your contribution.
- The next 5% of your contribution is not matched.
All told, in this example, your employer contributes an extra 4% of your salary to your 401(k) as long as you contribute at least 5% of your salary. That’s an immediate 80% return on investment.
That’s why it’s so important to take full advantage of your 401(k). There’s really no other investment that provides such an easy, immediate and high return.
How to find your 401(k) employer matching program
On a personal level, taking full advantage of your employer match is simply a matter of contributing at least the maximum percentage of your salary that your employer is willing to match. In the example above, that would be 5%, but the actual amount will vary from plan to plan.
So your job is to find out exactly how your employer matching program works, and the good news is that it shouldn’t be too hard. These are the two main pieces of information you’re looking for:
- The maximum contribution percentage your employer will match. This is the amount of money you’d need to contribute in order to get the full match. For example, your employer might match your contribution up to 5% of your salary, as in the example above, or it could be 3%, 12% or any other percentage. Whatever this maximum percentage is, you’ll want to do what you can to contribute at least that amount so that you get the full match.
- The matching percentage. Your employer might match 100% of your contribution, or they may only match 50%, or 25%, or some combination of all of the above. This has a big effect on the amount of money you actually receive. For example, two companies might both match up to 5% of your salary, but one might match 100% of that contribution, and one might only match 25% of it. Both are good deals, but one is four times as valuable.
With those two pieces of information in hand, you’ll know how much you need to contribute to get the full match and how much extra money you’ll be getting each time you make that contribution.
As for where to find this information, the best and most definitive source is your 401(k)’s summary plan description, which is a long document that details all of the ins and outs of your plan. This is a great resource for all sorts of information about your 401(k), but you can specifically look for the word “match” to find the details on your employer matching program.
And if you have any trouble either finding the information or understanding it, you can reach out to your human resources representative for help. You should be able to find their contact information in the summary plan description.
Two big pitfalls to avoid with your 401(k) employer match
Your employer match is almost always a good offer, but there are two pitfalls to watch out for: vesting and front-loading contributions. Both of these could either diminish the value of your employer match or cause you to miss out on getting the full match.
Pitfall #1: Vesting
Employer contributions to your plan, including matching contributions, may be subject to something called a vesting schedule.
A vesting schedule means that those employer contributions are not 100% yours right away. Instead, they become yours over time as you accumulate years of service with the company. If you leave before your employer contributions are fully vested, you will only get to take some of that money with you.
For example, a common vesting schedule gives you an additional 20% ownership over your employer’s contributions for each year you stay with the company. If you leave before one year, you will not get to keep any of those employer contributions. If you leave after one year, you will get to keep 20% of the employer contributions and the earnings they’ve accumulated. After two years, you will get to keep 40%, and so on, until you’ve earned the right to keep 100% of your employer’s contributions after five years with the company.
Three things to know about vesting:
- Employee contributions are never subject to a vesting schedule. Every dollar you contribute and every dollar that money earns is always 100% yours, no matter how long you stay with your company. Only employer contributions are subject to vesting schedules.
- Not all companies have a vesting schedule. In some cases, you might be immediately 100% vested in all employer contributions.
- There is a single vesting clock for all employer contributions. In the example above, all employer contributions will be 100% vested once you’ve been with the company for five years, even those that were made just weeks earlier. You are not subject to a new vesting period with each individual employer contribution.
Should vesting affect how you invest?
A vesting schedule can decrease the value of your employer match. A 100% match is great, but a 100% match that takes five years to get the full benefit of is not quite as great.
Still, in most cases it makes sense to take full advantage of your employer match, even if it’s subject to a vesting schedule. And the reasoning is simply that the worst-case scenario is that you leave your job before any of those employer contributions vest, in which case your 401(k) would have acted just like any other retirement account available to you, none of which offer any opportunity to get a matching contribution.
However, there are situations in which a vesting schedule might make it better to prioritize other retirement accounts before your 401(k). In some cases, your employer contributions might be 0% vested until you’ve been with the company for three years, at which point they will become 100% vested. If you anticipate leaving your current employer within the next couple of years, and if your 401(k) is burdened with high costs, you may be better off prioritizing an IRA or other retirement account first.
You may also want to consider your vesting schedule before quitting or changing jobs. It certainly shouldn’t be the primary factor you consider, but if you’re close to having a significant portion of your 401(k) vest, it may be worth waiting just a little bit longer to make your move.
You can find all the details on your 401(k) vesting schedule in your summary plan description. And again, you can reach out to your human resources representative if you have any questions.
Pitfall #2: Front-loading contributions
In most cases, it makes sense to put as much money into your savings and investments as soon as possible. The sooner it’s contributed, the more time it has to compound its returns and earn you even more money.
But the rules are different if you’re trying to max out your employer match. The reason is that most employers apply their maximum match on a per-paycheck basis. That is, if your employer only matches up to 5% of your salary, what they’re really saying is that they will only match up to 5% of each paycheck.
For a simple example, let’s say that you’re paid $18,000 twice per month. So over the course of an entire year, you make $432,000. In theory, you could max out your annual allowed 401(k) contribution with your very first paycheck of the year. Simply contribute 100% of your salary for that one paycheck, and you’re done.
The problem is that you would only get the match on that one single paycheck. If your employer matches up to 5% of your salary, then they would match 5% of that $18,000 paycheck, or $900. The next 23 paychecks of the year wouldn’t get any match because you weren’t contributing anything. And since you were eligible to get a 5%, $900 matching contribution with each paycheck, that means you’d be missing out on $20,700.
Spreading out contributions to take full advantage of your employer match
Now, most people aren’t earning $18,000 per paycheck, so the stakes aren’t quite that high. But the principle remains the same.
Still, to get the full benefit of your employer match, you need to set up your contributions so that you’re contributing at least the full matching percentage every single paycheck. You may be able to front-load your contributions to a certain extent, but you want to make sure that you stay far enough below the annual $18,000 limit to get the full match with every paycheck.
Now, some companies will actually make an extra contribution at the end of the year to make up the difference if you contributed enough to get the full match but accidentally missed out on a few paychecks. You can find out if your company offers that benefit in your 401(k)’s summary plan description.
But in most cases, you’ll need to spread your contributions out over the entire year in order to get the full benefit of your employer match.
When to contribute more than is needed for your employer match
Maxing out your employer match is a great start, but there’s almost always room to contribute more.
Using the example from above, the person with the $3,000 per-paycheck salary would max out his or her employer match with a 5% contribution. That’s $150 per paycheck. Assuming 26 paychecks per year, that individual would personally contribute $3,900 to his or her 401(k) over the course of a year with that 5% contribution.
And given that the maximum annual contribution for 2019 is $19,000 for 2019 ($25,000 if you’re 50+), the person in the above example would still be eligible to contribute an additional $14,100 per year. In fact, this individual would have to set their contribution to just over 23% in order to make that full $18,000 annual contribution.
3 big questions to answer to decide whether to save more
To figure out if you should be contributing more to your retirement savings, there are three big questions you’ll need to answer
- Do you need to contribute more in order to reach your personal goals?
- Can you afford to contribute more right now?
- If the answer is yes to both #1 and #2, should you be making additional contributions to your 401(k) beyond the employer match, or should you be prioritizing other retirement accounts?
Question #3 is what we’ll address here. If you’ve already maxed out your employer match and you want to save more money for retirement, should you prioritize your 401(k) or other retirement accounts?
We’ll dive into that in the next section.
What other retirement accounts are available to you?
Your 401(k) is almost never the only retirement account available to you. Here are the other major options you might have to invest outside of your 401(k).
An IRA is a retirement account that you set up on your own, outside of work. You can contribute up to $6,000 per year for 2019 and 2020 ($7,00 if you’re 50+). Just like with the 401(k), there are two different types of contributions you can make:
- Traditional IRA contribution: You get a tax deduction on your contributions, your money grows tax-free inside the account and your withdrawals are taxed as ordinary income in retirement.
- Roth IRA contribution: You do not get a tax deduction on your contributions, but your money grows tax-free and can be withdrawn tax-free in retirement.
The big benefit of IRAs is that you have full control over the investment company you use, and therefore the investments you choose and the fees you pay. While some plans force you to choose between a small number of high-cost investments, IRAs give you a lot more freedom to choose better investments.
One catch for the Roth IRA is that there are income limits that may prevent you from being allowed to contribute or to deduct your contributions for tax purposes. If you earn more than those limits, a Roth IRA may not be an option for you.
Health savings account
In fact, health savings accounts are the only investment accounts that offer a triple tax break:
- Your contributions are deductible.
- Your money grows tax-free inside the account.
- You can withdraw the money tax-free for qualified medical expenses.
On top of that, many HSAs allow you to invest the money, your balance rolls over year to year and, as long as you keep good records, you can actually reimburse yourself down the line for medical expenses that occurred years ago.
Put all that together with the fact that you will almost certainly have medical expenses in retirement, and HSAs are one of the most powerful retirement tools available to you.
The catch is that you have to be participating in a qualifying high-deductible health plan, which generally means a minimum annual deductible of $1,350 for individual coverage and $2,700 for family coverage.
If you’re eligible, though, you can contribute up to $3,500 if you are the only individual covered by such a plan, or up to $7,000 if you have family coverage.
Backdoor Roth IRA
If you’re not eligible to contribute to an IRA directly, you might want to consider something called a backdoor Roth IRA.
The backdoor Roth IRA takes advantage of two rules that, when combined, can allow you to contribute to a Roth IRA even if you make too much for a regular contribution:
- You are always allowed to make non-deductible traditional IRA contributions, up to the annual $6,000 limit, no matter how much you make.
- You are also allowed to convert money from a traditional IRA to a Roth IRA at any time, no matter how much you make.
When you put those together, high-earners could make non-deductible contributions to a traditional IRA, and shortly after convert that money to a Roth IRA. From that point forward, the money will grow completely tax-free.
Though there are some potential pitfalls to backdoor Roth IRAs, it can be a good option to have in your back pocket if you are otherwise ineligible to make IRA contributions.
Taxable investment account
While dedicated retirement accounts offer the biggest tax breaks, there are plenty of tax-efficient ways to invest within a regular taxable investment account as well.
These accounts can be especially helpful for nearer term goals, since your money isn’t locked away until retirement age, or for money that you’d like to invest after maxing out your dedicated retirement accounts.
How to decide between additional 401(K) contributions and other retirement accounts
With those options in hand, how do you decide whether to make additional contributions, beyond the amount needed to max out the employer match, or to contribute that money to other accounts?
There are a few big factors to consider:
- Eligibility: If you’re not eligible to contribute to an IRA or HSA, a 401(k) might be your best option by default.
- Costs: Cost is the single best predictor of future investment returns, with lower cost investments leading to higher returns. You’ll want to prioritize accounts that allow you to minimize the fees you pay.
- Investment options: You should prioritize accounts that allow you to implement your preferred asset allocation, again with good, low-cost funds.
- Convenience: All else being equal, having fewer accounts spread across fewer companies will make your life easier.
With those factors in mind, here’s a reasonable guide for making the decision:
- Max out your employer match before contributing to other accounts.
- If your 401(k) offers low fees and investments that fit your desired portfolio, you can keep things simple by prioritizing additional contributions there first. This allows you to work with one account, at least for a little while, instead of several.
- If your 401(k) is high-cost, or if you’ve already maxed out your 401(k), a health savings account may be the next best place to look. If you can pay for your medical expenses with other money, allowing this account to stay invested and grow for the long term, that triple tax break is hard to beat.
- An IRA is likely your next best option. You can review this guide for a full breakdown of the traditional versus Roth IRA debate.
- If you’re not eligible for a direct IRA contribution, you should consider a backdoor Roth IRA.
- If you maxed out your other retirement accounts because your 401(k) is high-cost, now is probably the time to go back. While there are some circumstances in which incredibly high fees might make a taxable investment account a better deal, in most cases the tax breaks offered by a 401(k) will outweigh any difference in cost.
- Once those retirement accounts are maxed out, you can invest additional money in a regular taxable investment account.
Chris O’Shea contributed to this report.