A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account.
Investing in a 401(k) plan is the most simple and effective way to grow your nest egg. Most companies offer 401(k) plans to their employees. If your employer matches contributions, set a goal to contribute equal to your employer’s maximum match, generally 6% of your compensation.
If your employer doesn’t match, 401(k) plans are still a great way to get the tax deduction benefits with each paycheck deferral and gain access to a wide variety of investment options. One exception – if your employer does not match, and you plan to contribute less than $6,000, an IRA may be the better choice. Check out the IRA section of the Investing section for more info.
Start with 6% of your salary. If you can afford more, do it. If you can’t afford 6%, start with $50 or $100 per month. Whatever you can. This year the IRS has increased the maximum employee 401(k) contribution limit to $19,000 per year. The maximum contribution for 2018 was $18,500. Additional contributions can be made if you are age 50 or older. For 2019, that number remains at $6,000, which is also the same as the catch-up contributions in 2018 and 2017.
Traditional vs Roth
The biggest difference between a Roth and a traditional 401(k) is how and when you get a tax break: The tax advantage of a traditional 401(k) is that your contributions are tax-deductible in the year they are made. The tax advantage of a Roth 401(k) is that your withdrawals in retirement are not taxed.
Tough call. If you are just starting your career, go with a Roth. Otherwise, select a traditional or do a mix of both.
Generally, plans offer a full range of stocks, bonds and mutual funds ranging from small cap to large cap, domestic vs. international and low fee index funds. Unless you plan to monitor your investments daily, your best option is a target fund.
I personally invest in a Vanguard target fund through my employer 401(k) plan. What is a target fund? A target date fund is designed to provide a simple investment solution through a portfolio whose asset allocation mix becomes more conservative as the target date approaches. As an example, if you pick the Vanguard Target 2045 fund, the portfolio will be more heavily weighted towards stocks, gradually allocating to more conservative investments, such as bonds, are your target date approaches.