The following is a guest post by Jane Sanders from debtmanagement.net. Visit her site for tips on managing credit card debt.
So you just got new job or promotion with a fat, shiny paycheck? How should you allocate your riches? According to most financial experts (and any fiscally sensible saver), you should maximize your contributions to a 401K. They recommend this because, even if your company does not offer a matching amount, this strategy provides a fairly simple way to automate your savings while also lowering the amount you pay in taxes.
Despite these advantages, there are many who neglect the advice. To understand why maxing a 401K is a good thing, the negative aspects must be understood first. One of the major reasons a 401K is not funded to the maximum that people shy away from having such a great deal of money tied up in long term (very long term) investments.
Usually, the maximum allowable amount is a high percentage of your gross income (as much as 30-40 percent), and, for those just entering the work force, this is a lot to let go. To overcome this, make a budget of your necessary expenses, and you’ll see that there is probably enough left over.
Another reason why some shy away from maxing out is that there is sometimes only one open enrollment period. This means that once they’re in the plan, they cannot back out, and the money being taken out of the individual’s paycheck every month is put away whether they need the money that month or not. This can be overcome by creating an short-term or medium-term emergency fund that can be drawn from in times of need.
Now that we’ve dealt with the negatives, what are the positives? Saving for retirement in a 401K creates periodic, enforced savings. The money you put away is being backed by the federal government, meaning there will be money available when it is time for retirement.
Another major advantage for maxing out a 401K is the resulting decrease in federal income tax. Generally about 25-30 percent of your paycheck is taken from your gross income and paid toward your federal income taxes. Money contributed to your 401K is taken out before income takes, so the full of value of this portion of your paycheck can earn investment interest.
Having money in a 401K also opens up options for future investment strategies. Once money has adequately matured in the 401K, it can be used to buy stock, invest in money markets, or find other long term investment opportunities. This money should be grown in safe, steady investments so that will be waiting when you’re ready to retire.
Deciding whether or not to max a 401K can be a difficult choice, especially if you are just entering the workforce. Though costs may be high in current economic times, planning for the future is always the right thing to do. Maxing out your 401K is the best way to get the most out from your paycheck in a safe and legal way.
Editor’s Question: Readers, what do you think about the guest poster’s premise that maxing out your 401(k) is the best thing you can do with your paycheck?
That depends on your 401K provider. I can max out my 401K, I choose not to line the pockets of Edward Jones with 2.5% commissions and 12b-1 fees.
Realistically one can earn 5 or 6% annualized in the stock market, now if I have to part with 2.5% or more to my 401K provider, I don’t think it such a great idea.
It depends on your situation. We max out our plans because we can afford it. However, I know a few people that save so much for retirement that they don’t have enough money for day-to-day life (and they are not big spenders). So, they are saving (company doesn’t match), but they are also paying a lot every month on credit card interest. In that case, I don’t think it is best to max out your 401k.
If you can do it, max it out! I think this is 401k is one of the easiest investment vehicle for regular investors. As the writer pointed out, you already gained 20-30% from tax saving. With 401k you started way ahead of other investments.
Of course, you should have emergency saving and all consumer debt paid off first before investing in 401k.
One obvious reason is for taxes, company match and compounding/time. You can never have too much saved for retirement!
If I were to max out my retirement options that would be:
16.5K 403(b)
16.5K 457(b)
6% required retirement (+ 6% match)
5K IRA
My spouse has the same options. That’s an awful lot of money to go to retirement. Right now we’re doing a bit more diversification with our savings than maxing out our retirement. (We’re not doing the 457(b), and instead pre-paying the mortgage).
I do agree with Moneycone that if your employer doesn’t have good options and doesn’t match, then a tax-protected IRA is a better use of funds, at least for the first 5K.
For me, the tax advantage is huge as I come from a 2 income family and that 401K money would be taxed at a very high rate if It wasn’t squirreled away. The matching thing helps too but with how stocks have been the last 10 years alot of that has been eaten away with flat or negative returns.
My former employer had very crappy options (pretty much all i could do was buy their company stock or their mutual fund.) Moneycone is right. I would have been better off taking that money elsewhere as that individual stock did very poorly during this last downturn and I lost a very big chunk of my savings. These days I’m a lot more diversified and feel much better about my retirement.
Great post. The worst situation is a person who actually has leftover savings and not doing a thing about it due to ignorance or laziness. Tax savings is huge and historically you can earn better than a savings account. More education, more power, and more options.
All – thanks for your comments. It’s a strong statement when anybody says one course of action is the “best”, so I was curious what everyone’s feedback was. Good discussion. And for FirstGen – I like how you referred to money being “squirreled away” 🙂
Maxing out the 401k plans can do a lot of things such as getting lower taxable income (more refunds) and also accelerating your retirement goals since the more money you put in, the faster you can reach your number.