You’re probably familiar with the basics of a 401(k).
You know that it’s a retirement account and that it’s 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 know that your employer may offer some type of matching contribution.
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.
That’s what this guide is going to show you. We’ll tell you everything you need to know in order to maximize your 401(k) contributions.
The 4 Types of 401(k) Contributions You Need to Understand
When it comes to maximizing your 401(k), nothing you do will be more important than maximizing your contributions.
Because while most investment advice focuses on how to build the perfect portfolio, the truth is that your savings rate is much more important than the investments you choose. Especially when you’re just starting out, the simple act of saving more money is far and away the most effective way to accelerate your path toward financial independence.
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, adding more money to your 401(k) and getting you that much closer to retirement.
1. Employee Contributions
Employee contributions are the only type of 401(k) contribution that you have full control over and are likely to be the biggest source of your 401(k) funds.
Employee contributions are the contributions that you personally make to your 401(k). They’re typically set up as a percentage of your salary and are deducted directly from your paycheck.
For example, let’s say that you are paid $3,000 every two weeks. If you decide to contribute 5% of your salary to your 401(k), then $150 will be taken out of each paycheck and deposited directly into your 401(k).
There are two different types of employee contributions you can make to your 401(k), each with a different set of tax benefits:
- Traditional contributions – Traditional contributions are tax-deductible in the year you make the contribution, grow tax-free while inside the 401(k), and are taxed as ordinary income when you withdraw the money in retirement. This is just like a traditional IRA. All 401(k)s allow you to make traditional contributions, and in most cases your contributions will default to traditional unless you choose otherwise.
- Roth contributions – Roth contributions are NOT tax-deductible in the year you make the contribution, but they grow tax-free while inside the 401(k) and the money is tax-free when you withdraw it in retirement. This is just like a Roth IRA. Not all 401(k)s allow you to make Roth contributions.
For more on whether you should make traditional or Roth contributions, you can refer to the following guide that’s specific to IRAs but largely applies to 401(k)s as well: Guide to Choosing the Right IRA: Traditional or Roth?
Maximum personal contributions
The IRS sets limits on how much money you can personally contribute to your 401(k) in a given year. For 2017, employee contributions are capped at $18,000, or $24,000 if you’re age 50 or older. In subsequent sections we’ll talk about how much you should be contributing in order to maximize these contributions.
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 401(k) contributions are contributions 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 what. Or they 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, they 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 they 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 401(k) contribution is rare. Many 401(k) plans don’t even allow this type of contribution, and even when they do, these contributions are rarely utilized.
The big catch is again that most 401(k) plans don’t allow these contributions. You can refer to your 401(k)’s summary plan description to see if it does.
And even if they 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).
Here’s how they 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.
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. But the $5,000 that is due to investment returns — your earnings — is taxed as ordinary income.
This hybrid taxation means that on their own non-Roth after-tax 401(k) contributions are typically not as effective as either pure traditional or Roth contributions.
But they can be uniquely valuable in two big ways:
- You can make non-Roth after-tax contributions IN ADDITION to the $18,000 annual limit on regular employee contributions, giving you the opportunity to save even more money. They are only subject to the $54,000 annual limit 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
With an understanding of the types of 401(k) contributions available to you, it’s time to start maximizing them. And the very 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.
You won’t find that kind of deal almost anywhere else.
Here’s everything you need to know about understanding how your employer match works and how to take full advantage of it.
How a 401(k) Employer Match Works
While every 401(k) matching program is different, and you’ll learn how to find the details of your program below, a fairly typical employer match looks like this:
- Your employer matches 100% of your contribution up to 3% of your salary.
- Your employer also matches 50% of your contribution above 3% of your salary, up to 5% of your salary.
- Your employer does not match contributions above 5% of your salary.
To see how this works with real numbers, 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 every time you receive a paycheck, and your employer matching contribution breaks down like this:
- 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 401(k) employer match is simply a matter of contributing at least the maximum percent of salary that your employer is willing to match. In the example above that would be 5%, but the actual amount varies from plan to plan.
So your job is to find out exactly how your 401(k) employer matching program works, and the good news is that it shouldn’t be too hard.
There are 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, and 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 in order 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 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 When Maximizing Your 401(k) Employer Match
Your 401(k) employer match is almost always a good deal, 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 401(k) 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 401(k) employer 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 it will be 40%, and so on until you’ve earned the right to keep 100% of that money 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.
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 401(k) 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 401(k) 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.
Now, most people aren’t earning $18,000 per paycheck, so the stakes aren’t quite that high. But the principle remains the same.
In order to get the full benefit of your employer match, you need to set up your 401(k) 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 401(k) 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 2017 is $18,000 ($24,000 if you’re 50+), he or she would still be eligible to contribute an additional $14,100 per year. In fact, this individual would have to set his or her 401(k) contribution to just over 23% in order to make that full $18,000 annual contribution.
3 big questions 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?
Let’s dive in.
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.
An IRA is a retirement account that you set up on your own, outside of work. You can contribute up to $5,500 per year ($6,500 if you’re 50+), and just like with the 401(k) there are two different types:
- Traditional IRA – 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 – You do not get a tax deduction on your contributions, but your money grows tax-free and can be withdrawn tax-free in retirement.
You can read more about making the decision between using a Roth IRA or a traditional IRA here: Guide to Choosing the Right IRA: Traditional or Roth?
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 401(k)s force you to choose between a small number of high-cost investments, IRAs give you a lot more freedom to choose better investments.
The only catch is that there are income limits that may prevent you from being allowed to contribute to an IRA or to deduct your contributions for tax purposes. If you earn more than those limits, an IRA may not be an option for you.
Health Savings Account
Health savings accounts, or HSAs, were designed to be used for medical expenses, but they can also function as a high-powered retirement 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 $1,300 for individual coverage and $2,600 for family coverage.
If you’re eligible though, you can contribute up to $3,400 if you are the only individual covered by such a plan, or up to $6,750 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 $5,500 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.
There are some potential pitfalls, and you can review all the details here. But if you are otherwise ineligible to make IRA contributions, this is a good option to have in your back pocket.
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 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 401(k) 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 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.
The Bottom Line: Maximize Your 401(k)
A 401(k) is a powerful tool if you know how to use it. The tax breaks make it easier to save more and earn more than in a regular investment account, and the potential for an employer match is unlike any opportunity offered by any other retirement account.
The key is in understanding your 401(k)’s specific opportunities and how to take maximum advantage of them. If you can do that, you may find yourself a lot closer to financial independence than you thought.
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