If you work for a traditional employer, there’s a good chance you’re saving for retirement in a 401k (or some variant, such as a 403b for employees of nonprofit organizations). While this type of account isn’t as meaty as the defined pensions offered to previous generations, you can still leverage your 401k’s benefits to invest for a comfortable retirement.
The good news is, 401k contribution limits are quite high — more than triple the contribution limits for IRAs — allowing you to sock away a significant amount of money for retirement every year. The rules change often, however, so it’s important to stay up to date with changes if you want to max out your contributions each year.
Since your 401k contributions are tax advantaged, you may also save on your tax bill by contributing as much as you can. As an added bonus, many companies offer an employer match – meaning they’ll match any contributions you make, up to a certain percentage of your salary. While you need to save some of your own money to receive the match, it’s one of the closest things to free money you’ll ever find.
Below we’ll look at the 401k contribution limits for 2016, plus the benefits and drawbacks that come with these common retirement plans.
401k Contribution Limits for 2016
Before we dig in any deeper, let’s look at the contribution limits for this year — the maximum amount you can dump into your 401k for tax year 2016. These limits do not include any funds you receive as an employer match, however.
|Age Bracket||Maximum Contribution for 401(k)|
|Under 50||$18,000 in 2016|
|Ages 50 and over||$24,000, including base maximum and $6,000 as an annual "catch up contribution"|
How Much Should You Contribute?
Now that you know the maximum allowable contribution limits for your 401k, you need to figure out the right amount for your own financial situation. Obviously, contributing more to your 401k plan or even maxing it out can help you grow your nest egg faster and retire sooner. On the other hand, you still need to have enough cash in your take-home paycheck to live and cover your monthly expenses.
A lot of workers base their 401k contribution on a percentage of their income. Most financial advisors suggest contributing at least 10% of your income to your tax-advantaged retirement plan, although it’s smart to boost that percentage incrementally if you can afford it.
At the very minimum, you want to make sure you’re contributing enough money to get your full employer match. If your company matches contributions up to 5% of your salary, for example, you should consider a 5% contribution to be your bare minimum. Remember, your employer match is essentially free money. With the help of those matching funds, your nest egg can grow and compound much faster than it would otherwise.
Your 401k: Downsides and Drawbacks
While saving for retirement in a tax-advantaged 401k plan is certainly better than nothing, there are some notable downsides to consider. These drawbacks can vary from plan to plan, which is why it’s crucial to explore each of these issues before you start contributing more to your company’s plan.
First off, some 401k plans often come with limited investment options. We intentionally say “some” investment plans work this way, because each plan is different, and yours might be great. Where some plans offer an array of investments to choose from, others only offer a small sampling of high-priced mutual funds. And if you don’t like those options, you’re mostly out of luck – unless it’s a very small company and you can convince the top brass to change the investment options. Remember, investing in an employer-sponsored 401k plan means you’re stuck with the options your employer chooses.
Second, some 401k plans are expensive to use and operate. These expenses are passed down to you, the consumer, in the form of expense ratios and administrative fees. Unfortunately, these higher fees can methodically chip away at your earnings over time, leaving you with a smaller 401k balance in the end.
If you find your 401k offers limited or expensive investment options, it might be smart to consider contributing enough to your 401k to get your employer match, but stashing the rest of your retirement funds elsewhere.
- Related: What to Do if Your 401(k) Stinks
Other Retirement Accounts that Make Sense
If you’re not in love with your work-sponsored 401k due to minimal options or high fees, it can make sense to invest at least part of your retirement savings elsewhere. Two different types of accounts – the Roth IRA and the traditional IRA – make it easy to save for retirement with any combination of investments you choose.
With a traditional IRA, your contributions are tax-advantaged in the same way as your 401k contributions are. You can take the tax deduction in the same year your contribution is made, up to certain limits. The best part is, you get to choose a brokerage account and the type of funds to invest in when you open your own traditional IRA. This includes the option to stash your money into low-cost index funds and call it a day.
With a Roth IRA, you also get to choose a brokerage account and your own investments. The big difference is, the tax break comes in retirement, not this year. When you invest in a Roth IRA, you use after-tax money to fund your account. On the upside, you won’t have to pay taxes on your distributions once you reach retirement age. As an added bonus, you can withdraw your contributions (not your earnings) from a Roth IRA at any time without paying a penalty or taxes.
The Best Way to Save for Retirement
No matter how you fund your retirement, the best time to start saving is now. For every year you fail to save, you could miss out on significant gains and compounding that might make retiring easier.
Even if you need to start with small contributions at first, you can always boost your contributions as you mature in your career and your income grows. The most important lesson to remember is that you have to start early if you want to give your money time to grow.
At the end of the day, the best way to save for retirement is slowly and over a lifetime. A 401(k) won’t help you get rich overnight, but it can help you grow wealthy if you have enough time on your side.
- Roth IRA or 401k? You May Not Have to Choose
- How to Roll Over a 401k
- What to Do With Your 401k When You Change Jobs
- How to Choose Investments in Your 401k
- The $15 Retirement Plan
How much did you contribute to your 401(k) last year? How do you plan to boost your earnings next year?