Frequently asked question:
Contributing to a 401k is a great way to help build wealth and financial independence. For most people, the main question is how much can I contribute to my 401k? Whenever I hear this question I take it to be asking something slightly different depending on the person:
For this post, we won't be diving into how much you should be contributing. That is a more complex answer that deserves it's own post since everyone's answer will be different. In another post we will provide the framework for figuring out your best contribution percentage. In this post, let's stick to the mechanics and facts of the 401k.
In case you aren't familiar with a 401k, here is a brief synopsis. The 401k is a tax-advantaged account that allows people to invest money pre-tax. Most people contribute to a 401k via their employer who offers a 401k through a provider. If your employer doesn't offer a 401k, don't worry there are still options. You can set up a self-directed 401k that you manage yourself.
While contributing to a 401k is great, there are some rules that you need to abide by. The IRS has set up some guidelines that one must follow to receive the tax advantages. If you don't follow these rules, you can be penalized and lose the advantages of investing pretax money.
Rules of the 401k
The rules of a 401k are pretty simple. There are income and contribution limits for the account. In 2019 these limits are:
If you are under 50 the maximum you can contribute to your 401k is $19,000 a year as of 2019. If you are over 50 your limit is $25,000. Remember these are the maximum limits. The average US employee contributes just under an average of 7% to their 401k, if they contribute at all. This percentage is less than half of 15-20% that most financial advisors recommend.
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The max income rule was a bit confusing for me. After doing some research, the max income doesn't mean you can't contribute to a 401k at all, it means that any employer match can only be on the first $280,000 of compensation. The IRS has a good example where an employee made $330,000. Her employer could only contribute the 5% match on the first $280,000 of her salary. While this would be a nice problem to have, many of us will not have to worry about this. I kept it in here to be accurate.
Like most things with the IRS, there are some other rules if you are highly compensated which is defined as over $125,000. You can still contribute to a 401k, but you must be within 2% of what a non highly compensated employee contributes. For example, if non highly compensated employees contribute an average of 6% to their 401k, the max you can contribute is 8%.
Over time, small contributions really add up. Let's run through an example of a single person named Jim:
Starting amount: $0 | Additional yearly: $3,000 | Growth Rate: 7.0%
Value after 30 years: $303,219.18
After Jim's working life of 30 years he will have over $300,000 without any salary or contribution increases. While this may not be to enough to retire on forever, it is much more than the average retiree. $300,000 is no small sum.
If you have the option of contributing to the 401k, I highly recommend you take a look and think about contributing. Many employers off a match on 401k accounts and if you don't at least get the match, it is like giving up free money. If you already haven't got one set up, talk with benefits at work to see if you can get started.