What Is a 401(k) and How Much Should You Save for It?

By Nadya JosifovLast Updated November 29, 2020
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Are you planning to work for your entire life? If you’re like most people, you probably envision yourself enjoying a relaxing retirement once you reach a certain age — and you’re probably also thinking about how you’re going to afford the life you want when you’re no longer earning a paycheck. Perhaps you’ve even started saving already but are thinking you want to get more serious about it. And that’s a good thing; the sooner you start saving intentionally and with a plan in place, the more comfortable your life has the potential to be during your retirement.

One of the most common tools for saving funds to use during retirement is a 401(k). No matter how long you’ve been in the workforce, it’s likely you’ve heard this term. But what exactly is it, and how can it help you? Whatever your age and current plans for funding your retirement lifestyle, it’s essential to learn more about 401(k)s and the ways to determine whether you're on track for accomplishing related financial goals.

A 401(k) Is Your Ticket to a Financially Secure Retirement

Let’s start with the basics. A 401(k) is a special type of investment account in which you deposit and accumulate money for use during retirement. It’s run by your employer, who diverts a portion of your paycheck directly into this special savings account before any taxes are taken from your pay. The money that you opt to have withheld from your paycheck and deposited into a 401(k) doesn't just sit in an account but is invested so the 401(k) increases in value over time and earns you more money to use for retirement. Every type of plan offers a different range of investment options, which typically include stocks, money market investments and bonds. You can often choose which of these investment products you want your money put into.

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Employers commonly match the contributions employees make to their 401(k) plans — meaning the employer deposits some of its own money — up to a certain amount. According to investment management company Research Financial Strategies, the most common employer match is 50 cents for every $1 an employee diverts into their 401(k), with employees depositing up to 6% of their salaries into the retirement plans.

This means that, if you set 6% of your pre-tax earnings aside for your 401(k) each month, your employer will also add what equates to 3% of your earnings to the retirement account. It’s important to remember that these numbers are just what’s most common, and your company’s matching policy may involve different amounts. Each plan has different rules and caps on what amounts you can invest, too. You can usually invest more than your employer will match — up to a 401(k) contribution maximum of $19,500 yearly or $26,000 if you’re over age 50, which are limits imposed by the IRS.

In a traditional 401(k) plan, the deductions from your salary that are used to fund the retirement plan are made before taxes are taken out of your paycheck. And the amounts deposited into your 401(k) are not included as taxable income when it comes to file and pay your taxes. That means that your taxable income for the year goes down by every dollar that you put into your 401(k) — it’s an incentive to maximize your contributions each year. This all sounds great, and a 401(k) is an efficient and effective way to simplify the process of saving for retirement. But there are some restrictions and stipulations involved.

What Are a 401(k)’s Limitations?

Typically, you can’t access the funds in your 401(k) without penalty until you’re 59 1/2 years old — unless you leave your job after the age of 55 (or 50 if you’re a public safety worker) or you become permanently disabled. If you leave your job before that or you do remove funds earlier than that date, you’ll have to pay a penalty that’s typically 10% of the withdrawal plus taxes. The employer who sponsored the 401(k) may also withhold some of the money you cash out, as they’ll need to pay taxes on it. The amount you cash out counts toward your income for the year you withdraw it, so you’ll also pay federal income taxes on it.

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It’s essential not to forget taxes when discussing 401(k) distributions. Although you don’t pay taxes on the money you deposit into your 401(k) account when you’re initially funding it while working, you do pay taxes on the money once you start taking disbursements during retirement. The IRS considers this money income, so it’s subject to taxation — your 401(k) plan isn’t a way to eliminate paying taxes entirely, but a way to delay the payment of taxes while your money is invested to earn returns. The tax rate applied to your withdrawal will depend on your income in that year.

How Much Should Be in Your 401(k) — and When?

Now that you understand the basics of a 401(k), it’s important to learn how to use it to its full potential. If you don't have a pension plan or other savings outside your 401(k), you may rely entirely on withdrawals from your 401(k) and on Social Security checks to cover your living expenses during retirement. For that reason, it's important to know just how much you need to save in your 401(k) to live beyond retirement (and to pay taxes on the amounts you withdraw).

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A May 2019 report by CNBC titled "How much money Americans have in their 401(k)s at every age" revealed average balances in Americans' 401(k) plans based on data from financial services company Fidelity Investments, which manages over 27 million 401(k)s and individual retirement accounts (IRAs). According to the report, these are the typical 401(k) balances various age groups hold in their retirement accounts:

  • Savers in their 20s: $11,800 on average with an average contribution rate of 7% of income
  • Savers in their 30s: $42,400 on average with an average contribution rate of 7.8% of income
  • Savers in their 40s: $102,700 on average with an average contribution rate of 8.5% of income
  • Savers in their 50s: $174,100 on average with an average contribution rate of 10.1% of income
  • Savers in their 60s: $195,500 on average with an average contribution rate of 11.2% of income

The amount you'll need to fund your retirement depends on a range of factors, including your goals, your preferred lifestyle and the age when you want to stop working. Because these variables can result in a variety of different outcomes for you, Fidelity, as a rule of thumb, recommends using the following as benchmarks to have deposited in your 401(k) account when planning for saving:

  • The amount of your salary by age 30
  • Three times your salary by age 40
  • Six times your salary by age 50
  • Eight times your salary by age 60
  • Ten times your salary by age 67

At first glance, those figures may seem low. Even at the upper end of Fidelity's rule of thumb, ten times your salary in your 60s is about $700,000. Will that really pay for retirement? Don't you need millions?

Don't forget about the investment returns that your 401(k) contributions generate and the power of compounding those returns year after year. An October 2020 report from Personal Capital demonstrates what you can expect to accumulate based on your savings. The report makes an assumption of 8% annual returns, an initial $8,000 investment at age 23 and a $19,500 investment every year thereafter (the 401(k) annual contribution maximum). Based on these assumptions:

  • At age 25, you'll have invested $47,000 but will have a total of $53,136.00.
  • At age 30, you'll have invested $144,500 but will have a total of $201,624.83.
  • At age 40, you’ll have invested $339,500 but will have a total of $740,379.90.
  • At age 50, you'll have invested $534,500 but will have a total of $1,903,511.67.
  • At age 60, you'll have invested $729,500 but will have a total of $4,414,625.94.

While 401(k) plans certainly aren’t the only type of retirement savings tool available, they're a popular one. They’re relatively easy to understand and to fund, and they simplify the process of helping you accumulate money to pay for your needs and lifestyle during your golden years. You’re never too old to start contributing to a 401(k), and every amount added helps move you closer to a more financially secure retirement.

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