If your company sponsors a 401(k) plan, your employer may offer a match. Make certain that you are contributing at least enough in 2017 to get the full match. Remember, your full match is essentially free money. The same is true when you are setting up your 2018 contributions later this year.
Example 1: Jill Myers earns $100,000 a year working for a company that offers a 50% match on 6% of pay. For Jill, 6% of pay is $6,000. So Jill must be sure that she has contributed at least $6,000 to her 401(k) in 2017 to get a $3,000 match. She will also need to contribute at least that much in 2018. That is an assured 50% return on her money.
Traditional 401(k) vs. Roth 401(k)
Many companies now offer both a traditional 401(k) and a Roth 401(k). With the traditional version, contributions reduce taxable income and the current tax bill. However, future distributions will be taxable. Roth 401(k) contributions offer no current tax benefit. But distributions will all be tax-free after age 59½ if you have had the account for at least five years.
If both versions are available, which should you choose for 2018 contributions? Employees in relatively low tax brackets may prefer the Roth 401(k). The current tax savings will be modest and the advantage of tax-free withdrawals in retirement may be significant.
Employees in higher brackets may opt for the traditional 401(k) for upfront tax reduction. That is especially true for those who expect to be in a lower tax bracket after retirement. On the other hand, even plan participants with high income might choose the Roth side. They may wish to have a source of tax-free cash flow in retirement if they already have ample pretax funds in the traditional 401(k). Note that all matches to a Roth 401(k) contribution will go into the participant’s traditional 401(k) account.
In 2017, the maximum you can contribute to a 401(k) as a plan participant is $18,000, or $24,000 if you will be at least age 50 at year-end. As of this writing, the 2018 limits have not been released. But some estimates indicate they could be $18,500 and $25,000. When you are finalizing your 2017 contributions and setting the amounts of income you will place in the plan in 2018, should you choose the maximum amounts? That could be a savvy selection, but you should consider the alternatives.
Alternatives to 401(k) Contributions
Instead of maxing your 401(k), you may prefer to pay down any credit card balances. Credit card interest is not tax deductible. So paying off a card with a 15% interest rate is the equivalent of earning 15%, after tax, with no investment risk. It is possible you will earn that much or more with an unmatched 401(k) contribution, which offers tax deferral, but that is not a sure thing.
Related article: Should you save for retirement or pay off credit card debt?
The choice between unmatched 401(k) contributions and paying down a home mortgage or student loans is a tougher call. Mortgage interest usually is tax deductible, and student loan interest might be, as well.
Example 2: Jill Myers has a mortgage with a 4% interest rate. In her 25% tax bracket, Jill’s return on paying down the mortgage would be 3%, and after tax, 75% of 4%. Jill believes she could earn more than that in her 401(k). So she increases her 2017 contributions to her 401(k) at year-end. She also raises her contributions for 2018, rather than planning on sending extra amounts to reduce her mortgage balance.
If her company does not offer a Roth 401(k), Jill may have to make another choice. She could reduce the amount she will specify for unmatched 401(k) contributions and plan to contribute to a Roth IRA instead. As is the case with a Roth 401(k), Taxpayers fund Roth IRAs with after-tax dollars but may deliver untaxed cash flow in the future. Roth IRA contributions in 2017 can be up to $5,500, or $6,500 for those 50 or older.
Example 3: Suppose Jill is age 40, and she has been putting $500 per month into her 401(k), for an anticipated total of $6,000 in 2017. As the year-end approaches, Jill believes she can contribute a total of $15,000 to retirement funds for 2017. Besides the $6,000 to get a full employer match in example 1, Jill decides to put $5,500 into a Roth IRA. She also decides to put a total of $9,500 into her 401(k). Therefore, Jill has her employer increase her 2017 401(k) contribution by $3,500. She also sets her 2018 contribution at $800 a month, or $9,600 a year. Jill has until April 17, 2018, to make her 2017 Roth IRA contribution.
Our office can look at your overall financial situation to help you decide whether you should increase your retirement plan contributions.