This fall, the 401(k) hit a milestone: it celebrated its 40th anniversary! But do you know how it came to be, and even more importantly, how to make the most of yours?
When Congress passed the Revenue Act of 1978, the bill included a provision allowing high earners a new way to save money on taxes: they could put bonus money or stock options in a special account to defer taxes to a later date. And this provision just happened to reside in “Section 401(k)” of the U.S. tax code.
In 1980, a benefits consultant figured out that this tax loophole could be valuable to the average worker by allowing pre-tax contributions and employer matching. And in 1981, the IRS ruled employees could contribute to a 401(k) account via salary deductions.
Voila, the 401(k) as we know it today was born.
As of June 2018, 401(k) plans house more than $5.3 trillion, which is about 20% of all retirement assets in the U.S. Here are Simply Money’s four biggest tips for using yours properly.
1. Save enough to at least get the match
If you do nothing else with your 401(k), at least follow this rule. Any match your employer offers is considered part of your compensation package. If you don’t take advantage, you’re missing out on money your company is earmarking specifically for you.
A common 401(k) match goes something like this: a company will give 50 cents for each employee dollar contributed, up to 6% of pay. So, for example, if you make $50,000 and contribute $3,000 a year (6% of your pay), your company will kick-in $1,500.
Not every employer offers a match, so if yours does, consider yourself lucky. Take the time to review your company’s specific matching rules and make sure you’re getting every penny.
2. Take advantage of catch-up contributions
If you’re age 50 or older, you can save more for retirement than your younger co-workers – $6,000 more a year, to be specific. This “catch-up contribution” bumps up your total 401(k) contribution limit to $24,500 in 2018 ($25,000 in 2019).
3. Have a Roth 401(k)? Use that as well
While the traditional 401(k) allowing for tax-deferred saving has been around for four decades, its cousin, the Roth 401(k), is much younger.
Stemming from the Economic Growth and Tax Relief Reconciliation Act of 2001 and officially introduced in 2006, a Roth 401(k) allows you to make after-tax contributions in order to get tax-free growth. And while a Roth IRA comes with income eligibility requirements, a Roth 401(k) does not.
According to a recent study from Willis Towers Watson, 70% of employers who offer a 401(k) plan now offer a Roth 401(k) option, up from just 46% in 2012. At Simply Money, we like the idea of diversifying your tax burden, so consider saving in both your 401(k) and Roth 401(k). Note: contribution limits apply to your 401(k) and Roth 401(k) combined.
4. Don’t touch it
More than 11 million workers take money out of their 401(k) for non-retirement needs every year.
This is a big no-no.
Your 401(k) should be reserved for retirement. Period. Do not think of it as a checking account, available to bail you out of a financial jam. Even though you can take out loans against your 401(k) doesn’t mean you should.
The reasons? You’re losing out on the potential of compounding growth. Plus, most plans don’t allow you to contribute any money until you pay back what you borrowed. Double whammy.
And if you leave your job, get fired, or are laid off, the loan becomes due. The IRS considers any amount not repaid as “income” and it will be taxed at your ordinary income tax rate (and you’ll have to pay an early withdrawal penalty if you’re younger than 59 ½).
The Simply Money Point
Pay attention to your 401(k). It’s probably the main way you’re saving for retirement, so don’t neglect it.
And to learn more about how to get on track to retire well, visit our Retirement Resources library. You’ll find video tutorials and downloadable guides, including “7 Simple Steps to Retirement Planning.”