Stashing enough in an employer-sponsored retirement plan to get the full match is a no-brainer—it’s free money toward your retirement. Employers often match contributions up to about 3–5 percent of an employee’s salary.
However, figuring out how much to contribute to a 401(k) beyond the match and how to divvy up funds within the account can be tricky.
The tax treatment of contributions and withdrawals is a top factor to consider. Most large employers’ 401(k) plans provide a Roth savings option along with traditional, pretax contributions. Roth accounts are often considered especially valuable for young investors because although a Roth offers no up-front tax break, withdrawals are tax-free in retirement, when investors may be in a higher tax bracket than in their early career.
With a traditional 401(k) account, contributions reduce your taxable income, but you pay income tax on withdrawals. Thanks to the recently passed Setting Every Community Up for Retirement Enhancement (SECURE) Act 2.0, employers may allow employees to have matching contributions directed to a Roth 401(k). Previously, matching contributions were pretax only.
Notably, SECURE Act 2.0 is also eliminating required minimum distributions for holders of Roth 401(k)s in retirement (the change takes effect in 2024); you also avoid Required Minimum Distributions (RMDs) with a Roth Individual Retirement Accounts (IRA). But as the rules stand now, millennial investors will still have to take RMDs from traditional IRAs and 401(k)s starting at age 75.
“The tax savings long-term on Roth money are exceptional,” says Bridget Costello, a certified financial planner in Los Angeles.
Still, millennials whose earnings are increasing may consider making pretax contributions, too. Costello, a millennial who plans to retire in 30 years or so, hedges her bets by splitting her 401(k) contributions evenly between Roth and traditional options. She expects her income to be lower in retirement than it is now, but tax rates may be higher by then, she says.
Financial advisers commonly recommend saving 10–15 percent of income for retirement. But it doesn’t have to be all in a 401(k).
Spreading your savings among various accounts can provide flexibility down the road. With a Roth IRA, you can withdraw contributions anytime without paying income tax or penalties (withdrawals of investment earnings before age 59½, however, may incur tax and penalties). That may prove valuable if you retire early or need to withdraw funds in a pinch. With a traditional IRA or 401(k) plan, you usually pay a 10 percent penalty as well as income tax on early withdrawals.
You typically have more investment options, such as the ability to buy individual stocks, in an IRA or a brokerage account than in a 401(k). Taxable brokerage accounts don’t have the tax benefits that retirement accounts offer, but you can withdraw from them anytime without penalty.
One other point to keep in mind: IRAs allow a $6,500 maximum contribution in 2023 for those younger than 50. You can stash more in a 401(k)—a total $22,500 in 2023 for those younger than 50.
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