How Contributions and Matching Actually Works in Your 401(k)

how-contributions-and-matching-work-401k

Your 401(k) is one of the best tools you have at your disposal to reach financial independence but without learning the contribution rules and how matching works in your 401(k), you could be missing out on ways to grow your wealth from this invaluable retirement account.

Did you know the average American worker will pay ~$138,000 in 401(k) fees? For many people, that amounts to an extra couple of years that they will have to work to have enough for retirement. (If this is news to you, you are not alone! 71% of Americans don’t realize that their 401(k) has fees.)

The good news is that once you understand how 401(k) contributions and matching works, you can also learn the basics of how to reduce 401(k) fees.

Let’s Start With What a 401K is and How it Works.

401(k)’s are employer-sponsored retirement savings accounts. This is a benefit that many employers offer to employees to help them save for retirement. The 401(k) was started in 1978 and has in many cases, completely replaced pensions.

If you are feeling lost when it comes to 401(k)’s you are not alone. There is no standardize 401(k) education in school or organizations as of this writing. This is where I come in as a financial coach and educator.

Your 401(k) is funded with pre-tax wages that are taken directly from your paycheck each pay period. This is a great way for many people to automatically save and invest for retirement.

How Do 401(k) Contributions Work?

You can choose how much you would like to contribute to your 401k account. When you contribute to your 401(k) you are investing into funds that hold stocks or bonds in the market. This means that the more you contribute, the more likely you are to grow your wealth because of compound interest.

Compound interest, simply put, is the interest you earn on interest. This creates exponential growth and is what makes investing such a powerful tool for retirement.

How Does 401(k) Matching Work?

Many employers will match up to a certain percentage of your contribution. For example, if your employee offers a match up to 4%, when you contribute 4% or more of your salary to your 401(k), your employer will add another 4% to your 401(k) on top of the amount you contribute.

If you are working for an employer that provides a 401(k) match, you should contribute at least the match to your 401(k). If you don’t, you are leaving money on the table that is part of your compensation.

For example, let’s say your employee offers a 401(k) match of 4%. If your salary is $100,000 and you contribute 4% of that to your 401(k), you will contribute $4,000 throughout the course of the year to your 401(k). Your employer will add another $4,000 on top of your contribution. This is the match and over time can add thousands of dollars to your 401(k) that can help you save more for retirement.

How Do 401(k) Taxes Work?

The traditional 401(k) works with pre-tax contributions. This means that whatever you contribute will be reduce your taxable income at the end of the year. Your 401(k) will grow tax deferred, meaning that the interest you earn in the account won’t be taxed until you take withdrawals in retirement. Withdrawals in retirement will be taxed as income.

There is another type of 401k that your employer might offer that is taxed differently.

You might have the opportunity to invest in a Roth 401(k). A Roth 401(k) is funded with post-tax dollars, while a 401(k) is funded using pretax income. This means that you don’t get to deduct your contributions from your income taxes if you contribute to a Roth 401(k), but you don’t have to pay taxes on investment growth OR in retirement when you withdraw the money.

I prefer the Roth option because I like the idea of paying taxes on my money now, so that I don’t have to deal with it in retirement.

IMPORTANT: With a Roth 401(k), the matching contributions provided by an employer are placed in a traditional 401(k), while employee contributions are held in the Roth 401k.

How Can I Make the Most of My 401(k) to Set Myself Up For Retirement?

One way you can make your 401(k) work for you is to reduce fees that can lower the amount of money in your 401(k).

Your 401(k) has administrative fees which pay for things like the platform that is being used to manage your 401(k). These fees are usually unavoidable (although if they are high you could bring it up with HR.)

While you can’t change the fees of your existing 401(k), once you leave an employer you can roll your 401(k) over to an IRA (individual retirement account) which can help reduce the administrative fees you may be paying.

The other fees in your 401(k) are what’s called expense ratios, which is the operating cost of any fund, expressed as an annual percentage. If you end up selecting investments with high expense ratios, you could be significantly decreasing the amount of money you will keep and compound on, over time.

Default investments like target date funds, tend to have high fees. Learning how to pick your own lower fee investments, like index funds, can help you keep and make more money.

What Should I Do With My 401(k) When I Change Jobs?

Your 401(k) is employer-sponsored, it doesn’t follow you automatically if you switch jobs. You have to remember to take it with you. You have four options of what to do with your 401(k) when you change jobs:

  • Cash it out
  • Leave it with your previous employer
  • Transfer it to your new employer
  • Roll it over to an IRA

I strongly recommend you roll your 401(k) over to an IRA. Here’s why:

  • IRA’s typically have lower maintenance fees than employer-provided 401(k)’s.
  • IRA’s often have a wider selection of investment options so that you can find the offer that best fits your needs and goals.
  • An IRA is still a tax advantaged retirement account!

Basically, an IRA in many cases will help you keep more of your hard earned money and I am all about that.

How Do I Roll Over My 401(k) to an IRA?

Don’t worry, the process couldn’t be easier if you use Capitalize, a COMPLETELY FREE service that finds your old 401k’s and rolls them into an IRA.

Not only does Capitalize handle the roll over, but they even help youc hoose the IRA that will best fit your needs. You won’t have to do ANY heavy lifting.

You should do it as soon as possible so that your money starts working harder for you. Capitalize can help you do it (for free) in only 15-20 minutes of your time.

Final Thoughts on 401(k) Contributions and Matching

Don’t wait to take control of your finances and your 401(k). Ensuring that you are contributing as much as you can to your 401(k) and at least contributing enough to take the match can make your retirement a lot more comfortable.

Managing fees can also save you thousands over time and rolling over your 401(k) to an IRA is one of the easiest ways to start reducing your investment fees.

To learn more about how to manage your 401(k) and to make sure you are making the most of your 401k, grab my free 401(k) checklist here.