The most common employer retirement plans are 401(k) plans, allowing for employee salary-deferral contributions, plus employer matching and/or profit-sharing contributions. Typically, employers match 50% of an employee’s first 6% of salary, given that the employee defers this much. Non-profit employers have similar situations under the 403(b) structure. Both are named for the section of the IRS Tax Code where Congress created them. There are other plans for federal employees and teachers, for example.
Congress realized that Social Security was inadequate to fully provide for worker’s retirement.
These plans were formed in the early 1980s to encourage Americans to save for themselves. The incentive (beyond capturing some additional funds from the employer) is that salary-deferral contributions are not taxed in the year they’re earned. Both deferral contributions and their investment earnings are taxed as income each year that the employee takes distributions.
Because most investors buy when markets are exciting (high) and sell when markets are scary (low), 401(k)s are often a retiree’s greatest investment. Employees keep the long-term mindset needed to stay invested during down markets. And, because investments are made with every paycheck, the money buys more shares when markets are down, which provides greater returns.
Unfortunately, many employees limit their contribution percentage to only that 6% needed to capture the employee match. Because 401(k) contributions are tax-deferred, the bite of increasing deferrals is softened. For example, if a couple’s taxable income is between $86,000 and $165,000, your next dollar is federally taxed at 24%. So, an extra $100 in your 401(k) per paycheck only reduces your take-home by $76. And you probably have state taxes, which lessen the impact as well.
If you’re good about paying off your credit cards and have a couple of months of emergency cash, we recommend investing your next dollar into your employer’s retirement plan for all the reasons above. In 2021 employees under 50 can defer as much as $19,500. For employees who reach age 50 before or during the year, they can add another $6,500.
Things To Consider
- To avoid liability after the tech bubble of 2001, employers have greatly narrowed plan investment choices.
- Many plans now restrict choices to “target date” funds and generic index funds.
- Both have issues that we’ll discuss in an upcoming blog.
Can’t wait for the next blog? Contact us to learn more about investing beyond the restricted choices in your retirement plan.