If you’re just getting started investing and work for a company that offers a 401(k) plan, you’re at the right place.
Why invest in a 401(k)? Between the tax breaks, free money from your employer, and investment growth, it’s one of the easiest ways to build wealth for your family. Here are 5 ways you’ll benefit from contributing to one.
(1) Get Your Employer Match
The “free money” part people always talk about sits at the top of why you should invest in a 401(k). You contribute some of your earnings, and then your employer throws a few (thousand) bucks your way to “match” your contribution.
Generally, matching happens in one of two ways: dollar-for-dollar or partial.
Dollar-for-dollar is just like it sounds. For every $1 you contribute, your employer puts in $1, up to a certain limit.
Let’s say you contribute 6% of your $50,000 salary. If your employer matches the full 6% you put in, that adds up to $3,000 from you and $3,000 from your employer, or $6,000 in total. In one year, you’re getting $3,000 of free money, just for deferring some of your salary.
Partial matching is when you contribute some money, then your employer matches a certain percentage of that. The most common partial matching scheme in the U.S. is when your company matches 50% of your contributions, up to 6% of your salary.
So, in order to take full advantage of the employer match in this example, you’d contribute 6% of your salary. Your employer would then sweeten the deal by contributing another 3% of your salary. If you make $50,000 per year, that tallies to $4,500 contributed to your account right there. $1,500 of this is free money from your employer.
Know that any money you contribute is always yours. Money your employer contributes on your behalf becomes yours once you’re vested. This usually happens after working for a company after a few years.
Related Post: Should I Quit Before Fully Vesting?
(2) Save on Taxes Now
Tax breaks are one of the major reasons why I’ve invested in a 401(k) consistently. Your contributions are tax deductible in the year you make them. In other words, investing in a 401(k) will reduce your tax bill, like majorly.
In 2023, you can contribute up to $22,500 to your 401(k) as a single taxpayer. That means you can reduce your taxable income by this amount. If you file taxes jointly with a spouse, and both of you contribute the 2023 max of $22,500, you can reduce your family’s taxable income by $45,000.
As a married couple, if you earn enough to breach the threshold of the 24% marginal tax bracket, maxing your 401(k)s will save you close to $10,000 in taxes. 🤯
Any money your company contributes to your account is in addition to the limit. The $22,500 max applies to your contributions only. Any amount that your company contributes, however, is not tax-deductible by you.
(3) Defer Taxes Until Later
Deferring taxes until later is the unsung hero of why you should invest in a 401(k). Investments in your 401(k) account grow tax-free, no matter what you buy or sell over the years, as long as the money remains in your account.
This gives you flexibility to make portfolio changes without worrying about tax consequences. It also saves you income taxes on dividends or interest your portfolio generates in any given year. (In a taxable account, taxes are due in the year these are earned.)
401(k) assets are taxed at your income tax rate only when you withdraw them during retirement. If you’re in your 20s or 30s, this can mean decades of savings from tax-deferral, which supercharges how much your money compounds.
(4) Automated Investments
The hardest part about investing is remembering to actually do it consistently. Create the path of least resistance for yourself!
Why invest in a 401(k)? It’s inherently automated. Contributions come out of each paycheck based on the amount you designate, up to the IRS limit of $22,500 for 2023.
By regularly investing in a 401(k), you’re doing a fancy little finance trick called dollar cost averaging. (If you want to show your friends how deep you’ve spiraled down a personal finance rabbit hole, talk to them feverishly about this topic in casual settings.)
Dollar cost averaging happens when you invest a fixed dollar amount at regular intervals – exactly what you’re doing by putting a chunk of your paycheck in your 401(k). If and when markets fall, your money stretches further. It can buy more, cheaper shares. Conversely, when markets go up, your fixed amount buys less.
Some of the most successful investors of all time swear by automation and dollar cost averaging. It feels counterintuitive because (in theory) it’s so easy, but the math checks out.
(5) Diversified Investment Choices
Most company 401(k) plans have pre-screened diversified investment choices available to you. This makes it super easy to create a well-diversified portfolio by investing in a 401(k).
A great example of a diversified choice is a target date fund. Target date funds are like one-stop-shops for retirement investing. You literally pick just ONE, corresponding to the year you want to retire, and invest in it. Inside of that one fund is a diversified portfolio that holds a smorgasbord of stocks and bonds.
If you’re 25 and have a long time until you retire, a target date fund will invest mostly in stocks. If you’re 65 and approaching retirement, the fund will invest in more bonds to help stabilize the portfolio. It’s like it ages with you, so you can set it and forget it for years.
Related Post: Are Target Date Funds Good Enough?
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult with your financial advisor.