How much should you invest in a 401(k)?

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Home » Personal Finance » How much should you invest in a 401(k)?







How much should you invest in a 401(k)?












A ‘401 (k) plan’ is a tax favored defined contribution retirement plan that allows you a unique option of saving for retirement and reducing your tax liability at the same time. It effectively means that for every dollar that you put aside as saving for using it after retirement, the treasury awards you some additional cents! This tax award comes to you, courtesy section 401 (k) of Internal Revenue Code, hence the name.

Different 401 (k) plans can have different features, that may impact your decision to invest in that plan. Thus before you take a decision on how much to invest, you must fully understand the features of your plan. However, more important than that are the situations of your own income and factors that govern as to how much you need to save. All the relevant factors need to be taken in to account.









Instructions




1

RELEVANT FACTORS FOR DECIDING HOW MUCH TO INVEST IN 401(k) PLAN

Since all 401(k) plans may not be exactly alike, you must know the following features of your plan, before you can decide your strategy of investing in it.

1. EMPLOYER CONTRIBUTIONS : MATCHING OR NOT – Not all 401 (k) plans have the feature of matching contributions by employers. Some have a fix contribution, where irrespective of your contribution the employer will contribute a fixed amount. Commonly, however, the employer makes a matching contribution, subject to a certain limit, e.g.. 5 % of your annual compensation. In case of matching contributions, it makes more sense to invest as much as you can in the 401 (k) plan.

2. TRADITIONAL 401 (k) OR ROTH 401 (k) – There are subtle differences in traditional and Roth plans. In traditional plans, contribution is exempt from tax but withdrawals of contributions as well as earnings are taxed. In Roth accounts, contributions are not exempted but withdrawals as well as earnings are exempt after age of 59 1/2 years. So if you are currently in a higher tax bracket, it makes more sense to invest in a traditional plan, otherwise it would be preferable to invest in both partly, to allow greater flexibility.

3. INVESTMENT OPTIONS PROVIDED IN 401 (k) – Some but not all plans provide an option to the employee to invest the contribution in stocks, debt or annuities. It is better not to invest aggressively if such options are not provided. One should also find out as to how much of the investment is being invested in stocks of the employer to know the risk associated with it.

4. AGE – The most important factor in making a decision is your age. If you are nearing the age of retirement, it may be preferable to aggressively save and invest as much is possible in 401 (k) plans to avail the tax benefits, especially if you fall in a higher tax bracket. On the other extreme, if you have just started working and are looking to settle a household and get married, then you may decide to first take care of the present. Planning for retirement need not be done at the cost of your life, though you may still invest in 401 (k) for the sake of tax benefits, in a moderate way.

5. INCOME AND WEALTH – Those borne with a silver spoon, i.e.. substantial inheritance, should pay more attention to safeguarding their assets and ensuring a steady stream of income. For them, unless they are having income from work, limits for contributions to 401 (k) plan will be lesser. On the other hand, those with very few assets and approaching retirement must invest as much as they can.

6. LIFE STYLE & PROJECTED EXPENSES – If you are in your twenties, it may be virtually impossible to make any intelligent projection about your post-retirement expenses, though some experts keep trying and coming up with some figures. In such a case, instead of indulging in meaningless jargon of numbers, it would be preferable to save and invest prudently without compromising the present. I would advice not to put all your investments in any single 401 (k) plan because of the long vesting period of those investments. However, once you are in your forties and know the family and personal liabilities that you are likely to face in post retirement years, you should try to plan accordingly.

7. OTHER ALTERNATIVES FOR INVESTMENT – While investing, it is important to understand the after tax returns on investments, both in case of retirement plans and other assets. if the after tax return on other assets, like real estate or shares are likely to be substantially more than the investments in 401 (k) plans, it may be preferable to go for the assets with higher returns. However, the risk associated with these high return assets must be taken into account while making the decision. As a thumb rule, the higher your age, the lower risk you are advised to take.




2

CONCLUSION

How much a person should invest in the 401 (k) plans or other tax qualified retirement plans depend upon individual choice and situation. All the factors detailed above should be considered while making a decision, and the pros and cons of all alternatives should be considered. Moreover, such decisions need to be taken as a part of comprehensive retirement planning during which one should also plan to have an active retirement life with some part time or free-lance work to keep the body and mind active, and sufficient attention should be paid on health and insurance to keep the health related expenses to minimum.

Generally, those in higher tax brackets and close to retirement age should invest as much as is possible, in the 401 (k) plan. On the other hand, those in twenties and in low or exempt tax brackets may prefer to invest in other instruments that provide higher returns with higher risk. Generally, even for the young, it is preferable to keep investing steadily in plans like 401 (k) because of the tax benefits that add up to make substantial numbers because of the ‘compounding effect’. For those approaching retirement, this decision will also need to be linked with other decisions like investing in a residence, which can later be used by way of ‘reverse mortgage’ to provide a steady stream of income during the last years.













Tips & Warnings


Please note that you are advised to contact your Plan Manager before you take a final decision about investing in your 401(k) Plan.









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