4 Tips to Maximize Your 401(k)

In 1978 personal finance changed forever when Congress enacted Internal Revenue Code Section 401(k). This was the catalyst for America’s radical switch from retirement savings centered around an employer sponsored pension plan, to a retirement savings plan centered around 401(k) contributions. This new code gave employees the right to defer portions of their compensation stemming from bonuses and stock options within a tax advantaged vehicle. Shortly after, in 1981, the IRS instated rules allowing employees to contribute to their own 401(k) plans by way of salary deductions. Over the next 45-years, America would quickly become a predominantly 401(k) centered country: removing much of the risk for a successful retirement away from the employer and placing it in the hands of the employee. Chances are you yourself are using a 401(k) today as your primary means of saving for retirement. The question is, are you using your 401(k) effectively? And if not, what are tips and strategies you could be employing to maximize your benefit?

Use it or lose it. Like most retirement vehicles available today, we can only derive benefit from them if we are actively participating. Assuming you do have the ability to contribute to your 401(k) plan, it’s important to note that retirement contributions are specific to a given tax year. This means you can only contribute for that tax year during a certain window of time. After said window is up for the specific tax year, you can no longer make contributions and therefore lose the benefit for that year. For those just starting out, please don’t allow this window to put undue pressure on your finances. At the end of the day, your ability to contribute comes down to your specific financial picture. That said, also remember retirement comes faster than one might think. Assuming you start your working career at age 18, and retire at the average age of 64, this gives an estimated 46 years to contribute to retirement vehicles. That may sound like a long time but the runway (and benefits of compound interest) erode faster than you might think. If you aspire to a work optional lifestyle someday, please do not give up what you want most, for what you want now; prioritize your retirement savings. Instant gratification can quickly erode your dreams of a successful retirement.

Don’t just contribute, you want to invest your contributions! A 401(k) is what we in the business call an employer sponsored plan, and an investment vehicle. That is, it’s a vehicle you can utilize for your retirement savings/investing that is sponsored by your employer. The thing is, for the balance to grow above the money you and your employer contribute to it… you must invest it. A common assumption people make when contributing is that the assets or investments held within their 401k are being monitored and actively managed on their behalf. There are many horror stories out there of people putting money into their 401(k)s on a regular basis, only to find out years later that it hasn’t grown more than what they have put in it (or has lost money). In reality, the average 401(k) has 32 investment options - half of which are what are known as Target Date Funds. These 32 investment options are provided as a way for you to design a 401(k) that aligns with your financial strategy (assuming you have one), and hopefully grows over time. It is up to you to drive the ship as to how your 401k is invested. You should speak with an investment professional to help decide what investment allocation is best for you and your financial goals. But remember, simply putting money into your 401(k) will not allow it to grow above and beyond what you have deposited. In fact, after fees and expenses (yes, you do pay fees and expenses to have your 401(k)), you will have less money in the account if you leave it in cash, and the funds are unlikely to keep pace with inflation without being proactively invested. You will want to invest your contributions to try to obtain some sort of return on your asset.

Strive to meet the full company match as a starting point. Most of the time, your employer will offer you some sort of incentive match to contribute to the 401(k) plan they are offering. The most common employer match is 50 cents on the dollar up to 6% of wages.  This means the employer has opted to match a percentage of employee contributions, up to a set percentage of the employee’s total wages. It is important to note that when an employee does not utilize the full match their employer is offering, they are essentially choosing to leave “free” money on the table. I use quotes here because you as the employee have earned this match, and it is most certainly factored into what you are compensated by the employer at the time they offer you a job. You earned it, but you need to set yourself up properly to fully obtain it. Keep in mind, the match your employer contributes is based on a percentage of your contribution, not on total dollars. This means that to get the most out of your employer match, you need to be contributing the entire year. Simply put, if you don’t contribute, your employer doesn’t contribute. Easy as that.

If you are not contributing the IRS maximum annual contribution for the year, contributing year-round is less of an issue - all you have to do is set your desired contribution rate and contribute each pay period throughout the year. But what if you are contributing the IRS maximum amount (which is $23,000 for the 2024 calendar year)? What happens if you reach this max before year end, or your final paycheck? Well, you could be giving up money. To better understand this, let’s take a closer look at a hypothetical example.

Jane Doe works for ExampleCo who provides her with a dollar-for-dollar match on the first 5% she contributes. She makes a healthy $250k base salary. Great work Jane! Jane is financially savvy; she likes to keep up on things within the personal finance world and as an overachiever, follows the blanket advice of saving 10-15% of her wages towards her company’s 401(k). She gets paid twice per month, or 24 times per year. In simplistic terms, she is contributing $1,562.50 per pay period, while ExampleCo puts in $520.83. This means that she will reach the Employee Contribution limit of $23,000 imposed by the IRS after 15 paychecks (roughly the end of July). Further, this means at that point she will have contributed $23,000 to her 401(k) while ExampleCo will have matched only $7,812.45. Now Jane has maxed out the 401(k) for the given tax year. Since Jane can no longer contribute, ExampleCo is no longer matching. The problem is $7,812.45 is not 5% of Janes salary, it’s just over 3% - money has been left on the table! This is because ExampleCo, like most companies today, matches based on Jane’s contribution per pay period, not on her total dollars contributed. So, although Jane maxed out the 401(k) from her contribution standpoint (again, great work Jane!), she's missed out on additional matching funds because of the accelerated rate at which she chose to contribute. Fiddle sticks!

So, what should Jane do? In further reviewing her options with her CWM advisor, they agree that since her employer matches based on a contribution standpoint, not a total dollar figure - Jane ought to contribute in a way that stretches her contributions across the entire year, or all 24 pay periods. By adjusting her rate of contribution, Jane both improves monthly cash flow (by not withholding so much at once) and increases her employer’s 401(k) match from roughly $7,800 to $12,500 – an annual increase of ~60% and a simple change that can really add up over time!

Choose the option that is right for you. Nowadays, it is common for your employer to provide both Traditional 401(k) and Roth 401(k) options for you to participate in. What is the difference? It all comes down to the taxation of the accounts. The Traditional 401(k) is a pre-tax vehicle. By placing money into this account, that money lowers your total (gross) income for that tax year- making it so you pay less in taxes during that contribution year. Ultimately, you pay taxes on the contributions and the growth of those contributions at the time of distribution- which usually takes place upon withdrawal in retirement. Essentially, you get a tax break now, and you pay your taxes later on a larger amount, though perhaps in a lower tax bracket, assuming you make less income during retirement. Conversely, a Roth 401(k) is an after-tax option. The money you contribute to this plan today is made with after tax dollars (meaning you have already paid taxes on it in that given tax year) and grows tax free to and through retirement. At the time of withdrawal, you are not taxed on your distributions. In general, in using the Roth 401k option you’re assuming taxes and/or your income will be higher in retirement, so you may as well pay the taxes now. To make things even more tricky, you are allowed to make contributions to both of these options in the same tax year- but must stay at or below the annual IRS maximum for the given year. As always, you should consult with your Financial Advisor and tax professional as to which option (or blend of options) is best for you.

Of course, the tips and strategies discussed within this article are just the beginning. Your financial picture and what is right for you and your goals involves so much more than what you can learn from a brief article. Please, always consult a professional when making financial decisions- even one conversation per year could save you hundreds of thousands of dollars over the course of your lifetime.

If you are interested in a deeper dive into this or other financial topics, please Contact Us or call the office at (425) 778-6160 to schedule an appointment with your CWM advisor.

------------

PS – I may be a new face for many long-time CWM clients. Be sure to learn more about me here. I look forward to meeting you when you are next in the office or at an upcoming client event!

*For general educational purposes only. Not intended to replace advice from a financial professional. Please contact your Financial Advisor for specific questions regarding your retirement planning strategy.