Having a 401(K) plan is essential as it allows you to save for retirement and lower your taxable income. The 401(k) plan may also come with free money through matching contributions from your employer. If you have a 401(k) plan, you should make regular contributions to take advantage of its full benefits. Knowing how much you should contribute to your 401(k) plans, however, can be challenging due to your financial situation.
While some people might suggest contributing the maximum amount allowed by the IRS to your 401(k) plan, this might not always be the best choice for everyone. Before you make any contribution to your 401(k) plan, you need to evaluate your benefits, the risks and rewards of contributing the maximum amount, and other benefits you could get if you invested your money in other accounts such as IRA.
This article will show you exactly how much you should contribute to your 401(K) plan to maximize your retirement savings.
What is a 401(K) plan?
A 401(K) plan is a tax-advantaged retirement plan sponsored by employers that allows you to save for retirement. Your contributions to the plan come from your wages through payroll deductions. Most employers also match their employees’ contributions up to a certain percentage.
Having a pre-tax 401(K) plan helps you reduce your taxable income as your contributions are tax-deductible. Additionally, you will grow your account on a tax-deferred basis and pay income tax on your distributions.
What are the contribution limits for the 401(K) plan in 2024?
Before I walk you through how much you should contribute to your 401(k) plan, let’s see the maximum you can legally contribute to your 401(k) plan in 2024.
Since your 401(K) retirement plan is a tax-advantaged account, the IRS imposes a contribution limit on the plan. If there was no limit, some people would stash all their wages in their 401(k) accounts and pay zero tax. Unfortunately, Uncle Sam must get his share.
According to the Internal Revenue Service (IRS), the maximum contribution you can make to your 401(K) plan in 2024 is $23,000. Those who are 50 or older can contribute a catch-up contribution of $7,500 to catch up. In other words, people who are 50 or older can contribute as much as $30,500 in 2024.
For 2023, the max contribution to your 401(k) is $22,500 and those who are 50 or older can contribute an extra $7,500 to catch up. So, how much should you contribute to your 401(k)? Let’s explore that next.
How much should you contribute to your 401(k) plan in 2024?
Now that you know the highest amount you can legally contribute to your 401(K) plan; how much should you be contributing to your 401(K) plan?
To be honest with you, you should contribute the maximum allowed by the IRS for the year if you can afford to do so. This is because every dollar you contribute to your pre-tax 401(k) lowers your tax liabilities and you get to grow your funds without paying tax. When it comes to building wealth, retirement plans are the best vehicles to boost your net worth. That is why contributing as much as you can to your 401(k) is always the best idea.
If you are like millions of people who are struggling financially, maxing out your 401(k) might not be a viable option for you. Not everyone can afford to let go of $23,000 every year. So, how much should you contribute to your 401(K) if you cannot afford the maximum allowed by the IRS?
Let’s explore different options for making contributions to your 401(k) plan
- Contribute the maximum allowed by the IRS. You should contribute to your 401(k) the maximum allowed by the IRS If you can afford it. The maximum contribution to the 401(K) plan in 2024 is $23,000 or $30,500 for those who are 50 or older to catch up. Making these contributions will reduce your taxable income and help you grow your retirement savings on a tax-deferred basis and pay income tax when taking distributions.
- Contribute to your 401(k) at least the matching percentage. It is possible that you cannot afford to max out your 401(k) plan. I get it. You have bills to pay just like everyone else. If this is the case for you, try to contribute up to the matching percentage of your employer. The reason you need to make this contribution is that most employers match their employees ‘ contributions up to a certain percentage which becomes free money.
- Make contributions you can afford without putting stress on your finances. One of the benefits of 401(k) is that you can contribute as low as 1% of your gross income. This means that if you make $1,000 per pay period, you can contribute as little as $10. If you cannot afford the maximum allowed or at least match your employer’s matching percentage, contribute what you can afford. What matters is getting started and letting compounding interest do its thing.
- Contribute 10-20% of your income: If you are looking for a percentage of your income to contribute to your 401(K), allocate between 10%-20% of your income to your 401(k) plan. Keep in mind that your overall contributions should not go over the maximum contribution allowed by the IRS for the year.
What is the early withdrawal penalty on a 401(K) plan?
Withdrawing money from your 401(K) plan before you reach 59½ will trigger an early withdrawal penalty. Your retirement account is not like any other deposit account such as a checking account. You cannot get money out of your 401(k) plan whenever you want without paying a penalty. The IRS agreed to not charge you tax, and in return, you promised to not withdraw the money from the account until you retire.
Making premature withdrawals automatically violates these conditions. That is why you will pay a penalty.
According to the IRS, the penalty for early withdrawal on a 401(K) plan is 10% of the distribution. Besides this penalty, you will also pay tax on your distributions when you file your taxes. Paying a 10% penalty and tax on the money you took out at the same time reduces your take-home greatly. This is how people withdraw $50,000 from their 401(k) plans before they retire and end up taking home only $30,000.
Why should you open a 401(K) plan?
When it comes to building wealth and saving for retirement, investment strategies that lower your taxes are always the best.
By paying less tax, you get to use your money together with IRS money to build wealth and worry about tax after you are rich.
The 401(K) is a great tax reduction and investment vehicle. Many millionaires used 401(k) plans to build wealth and you can do the same. By putting away up to $23,000 or $30,500 if you are 50 or older, you automatically reduce your taxable income by the same amount. That means you only pay tax on the remaining amount. If for example, you made $40,000 for the year and contributed the maximum limit allowed to your 401(K) account; your taxable income will become $17,000 or $9,500 if you are 50 or older.
Additionally, the 401(K) has one of the highest contribution limits compared to other retirement plans such as Roth IRA and Traditional IRA. According to the IRS, the maximum contributions on IRAs in 2024 are $7,000 or $8,000 if you are 50 or older. This makes the 401(K) plan a winner when it comes to building wealth.
Furthermore, you might receive employer matching on your contributions. That is for every contribution you make to your 401(K) retirement plan, your employer will match it up to a certain percentage. For example, your employer will contribute 100% of your contributions if the matching percentage is 100% dollar to dollar. This will become free money in your account. Keep in mind that some employers have a vesting rule. This rule makes you work for the company for a given number of years before the matching contributions become 100% yours.
When can I safely take money out of my 401(K) without a penalty?
The money in your retirement account should not be taken out until you are in your retirement. Withdrawing money from your 401(K) plan before retirement will trigger a 10% penalty and tax on your distributions.
To avoid an early withdrawal penalty, you must be 59½ or older before you can withdraw money from your 401(k).
