When Does It Make Sense to Contribute to a 401(k) Plan?
401(k) plans are designed to help employees and self-employed individuals save money for retirement. It is assumed that your financial needs have been met if you are saving for retirement. Therefore, you should only contribute to your 401(k) plan if you have:
- An emergency fund: This could be a savings account or another deposit account. Having an emergency fund large enough to cover three to six months’ worth of expenses can help you avoid needing to withdraw money from your 401(k) plan. If you do this using a traditional 401(k) plan, it could increase your tax bill, and you may also incur a 10% early withdrawal penalty if you are under 59½ years old.
- Enough insurance coverage: This includes health insurance as well as property and casualty insurance, and may also include life insurance.
- A plan to pay off debt: If you have high-interest debt, you may want to pay that off before placing money into retirement savings. Try to pay down debt while saving for retirement simultaneously if possible.
How Do You Decide on the Contribution Amount for Your 401(k) Plan?
Review your financial situation and the company match contribution and contribution limits when determining how much of your salary you will contribute.
401(k) Contribution Limits
Be sure to stay within the legal contribution limits for a 401(k) plan. According to IRS guidelines, employees can contribute up to $19,500 to their 401(k) plan in 2021. In 2022, this limit increases to $20,500. In 2023, this limit rises to $22,500. If you are 50 years of age or older, you can add an extra $6,500 in “catch-up” contributions for 2022, or an additional $7,500 for 2023. This can give you a total of $27,000 in 2022 or $30,000 in 2023.
Company Match
If you work for a company, find out if they offer any type of matching contributions for your 401(k) plan. Depending on the matching formula, your company will partially or fully match your contributions to the plan up to a certain amount.
Your Current Age
If you are younger and have more time until retirement, you may be able to make smaller contributions to your 401(k) while still achieving your retirement goals.
The Amount of Money in Your 401(k) Plan and Other Accounts
Your 401(k) plan may just be one part of your larger retirement strategy. You may also have money in an IRA, pension plan, or other types of accounts. Review all of these accounts and their current balances. Then you can determine the role that your 401(k) plan will play in securing your retirement income.
What Are the Tax Implications of Contributions to a 401(k) Plan?
Once you determine how much money you will put into your 401(k) plan, consider the different types of contributions. Each type has unique tax treatment.
Tax Implications of a Traditional 401(k) Plan
Pre-tax contributions to a traditional 401(k) plan are not included in your taxable income for the year. They can reduce your tax liability for the tax year in which you contribute. However, you will pay income taxes—and possibly penalties—on withdrawals from a traditional 401(k) plan before taxes.
Tax Implications of a Roth 401(k) Plan
Contributions to a Roth 401(k) plan are made after taxes and grow tax-free. A Roth 401(k) plan is a unique type of 401(k) plan. It allows you to contribute after-tax dollars. These contributions are considered better if you believe
Source: https://www.thebalancemoney.com/how-much-should-i-contribute-to-my-401k-plan-2388217
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