Should You Contribute to a 401(k)?

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Retirement Savings: 401(k), IRA or Both?

It’s one of the fundamental rules of financial planning: you must save for retirement. But what is the best way to do it? Most people have access to a “defined contribution” retirement savings plan through their employers, like a 401(k).

What is a 401(k)?

This is a special retirement savings account where you can save money out of each paycheck and your savings are tax-deferred – meaning that you don’t have to pay taxes on the money in your account until you retire and start taking withdrawals to live off of that income.

Many employers offer a matching contribution, or “employer match,” to their employees’ 401(k) plans. This means that for every dollar you save for retirement, your employer matches your savings with some additional money. For example, your employer might have a plan where if you contribute 6 percent of your salary to your 401(k), your employer will match 50 percent of that amount, or 3 percent of your salary.

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Why is an employer 401(k) match so important?

If your employer offers a 401(k) match, you really need to make sure you save enough to receive that full amount of matching dollars – it’s like free money! An employer 401(k) match is like getting a free raise from your employer each year – if you don’t save for retirement, you’re missing out on getting some extra help from your company.

What if my employer doesn’t provide a 401(k) match?

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The biggest advantage of a 401(k), other than the tax-deferral benefit, is the employer matching funds – so if your employer doesn’t match your 401(k) contributions, you might want to consider some other retirement planning options.

Depending on your income, you might qualify for a Traditional IRA (Individual Retirement Account), where the money you save for retirement is tax-deferred. Another option is the Roth IRA. This is different than a 401(k) or Traditional IRA because your retirement savings are taxed up front – meaning you pay taxes on your contributions and that money can then grow tax-free for the rest of your life. This could be a big benefit to you later in life, as you’ve effectively already paid the tax bill for that retirement account.

I’m already saving enough to get the 401(k) match, but I want to save even more money for retirement – is a 401(k) the best place for extra retirement savings?

If you’re already saving the full amount in your 401(k) to qualify for the full employer match, most of the time, you’re probably better off putting any additional savings into a Roth IRA. It depends on your particular income and tax situation – there are income limits and annual contribution limits for the different types of retirement savings accounts – but in general, a Roth IRA is a better deal for your extra retirement savings.

Here’s why: look at how old you are, how much money you’re making and what tax bracket you’re in. Chances are, if you’re young and single, or even if you’re later in your career, you might be in the lowest tax bracket of your life. That means that putting money into a tax-deferred account like a Traditional IRA or 401(k) is going to leave you vulnerable to potentially paying higher taxes on that money years from now when you retire.

What if the government raises tax rates between now and then? (It’s quite possible – since America is facing big deficits.) By putting money into a Roth IRA (in addition to tax-deferred accounts like a 401(k) and Traditional IRA), you are increasing the “tax diversification” of your retirement funds. This gives you flexibility and protection when you’re in retirement; even if taxes are higher when you’re retired, you can still have a big pot of money in a Roth IRA that will provide you with tax-free income. For some people, it might even make sense to convert 401(k) accounts to Roth IRAs for tax advantages, but this process can be complicated and difficult to calculate.

Bottom line: a 401(k) is a great way to save for retirement if you get an employer match. If not or if you want to save even more than what your employer will match, you might be better off with a combination of Roth IRA and Traditional IRA savings.

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