There is often a lot of confusion between your annual limits of contribution, how much your company matches and how much it lowers your tax bill. I have yet to see a government program that is easy to understand so don't feel so bad for being a little bit confused.
2014 Annual Contribution Limits:
- Age 49 and Under: $17,500
- Age 50 and Over: $23,000
These amounts apply to 401(k) retirement accounts, which is the standard employer sponsored retirement account. If you work for a public school, a tax exempt organization or are a government employee, you could be enrolled in a 401(b) or 457 plan. Check with your employer if your uncertain.
For most people contributing the maximum amount allowed ($17,500 - $23,000) each year is unrealistic. It's a great New Year's resolution, should you want to shoot for the stars.
This is probably the single best part about participating in your company's 401(k) plan. It's the only place in the financial world where you can get 50-100% return on your investment. Check with your employer or HR personnel for details but usually works like this:
- 50-100% for every dollar you put into your account is matched by your employer.
- There is a set maximum for this amount, typically around 3-6% of your income. Anything around 10% or above is an amazing match.
- Your annual salary: $50,000
- Employer match dollar for dollar maximum: 5%
- If you add $2,500 to your account your company also adds $2,500!
That's a 100% return on your investment and that match doesn't increase your tax bill for the year. It's simply a great deal. At the very least your goal for the year should be contribute enough to your 401(k) so that you max out your company match.
Find out how much your company's maximum match is, contribute at least that every year, and don't make any excuses about how you can't afford it.
Investing your money:
A tragic but all too common mistake made is failure to actually investing the money added to the 401(k). Knowing that American's have taken the time to sign up and contribute to their 401(k) but then just leave their money in a checking or money market account pains me to no end. Your plan will consist of mutual funds or shares in your company's stock, if your company is publicly traded.
First Step: Find the expense ratio for the mutual funds offered in your plan. It's a percentage that represents a yearly cost of investing in that fund. Mutual funds offered in 401(k) plan have a terrible habit of being terribly expensive.
Second Step: Scratch out any mutual fund's with an expense ratio over 1%. If you company doesn't offer any funds with an expense ratio <1%, complain viscously, and increase your focus to funds with an expense ratio of 1.5% or less.
Third Step: Look for Index Funds. They should be the funds with the lowest expense ratio are the best bet for most investors. They're cheap, unbiased, and beat actively managed mutual funds 67% of the time.
Fourth Step: Use an asset allocate or retirement planner to calculate how much you want to invest in stocks or bonds. An old rule of thumb that still has merit is simply to buy your age in bonds. So if you 40, 40% of your invested money should be in bonds. When selecting a bond fund, make sure your pick a low cost index fund. The chance an actively traded bond fund, after the expense ratio, beats an index fund is very low.
The money you contribute to your 401k is done directly from your paycheck or what's called pre-tax dollars. By doing this, your lowering your yearly taxable income and effectively lowering your tax burden for that year. You get your tax benefit at the time of the contribution and can not take another deduction for these contributions when filling your taxes at the end of the year.