Millennials frequently ask me about 401(k) or 403(b) investment accounts: the why, the how, and the how much. For the sake of simplifying this topic, I’m going to refer to both the 401(k) and 403(b) as an “investment account”. They are essentially the same, but 403(b)’s are typically offered by non-profits as opposed to 401(k)’s offered by most other corporations.
**Disclaimer – I am not a certified financial expert. Read more about my disclosures here. You should consult a financial professional if you are in search of expert advice.
"Why Should I Contribute to My 401(k)?"
Why you should contribute is simple – you are throwing away thousands – if not, hundreds of thousands of dollars if you don’t.
There are two ways you are throwing away money by not contributing.
- Many employers match your contributions up to a certain percentage. This typically equates to thousands of dollars each year your employer will give you (via your investment account), just for contributing towards your retirement.
- You lose out on the potential growth of your investment account due to time. As a young adult, your best investment asset is time. There’s no reason why any full-time working millennial shouldn’t have a million dollars in their account by the time they retire if they are utilizing the tools available to them.
If you don’t believe me, take it from Patrick O’Shaughnessy who wrote “Millennial Money: How Young Investors Can Build a Fortune” (which I highly recommend, by the way):
“In 2013, the maximum contribution for 401(k) plans is $17,500 – a huge chunk of the median salary for a 25 year old. But consider this: if you maximize your 401(k) contributions from age 25 through retirement and earn a normal market return along the way, you’ll have $6.6 million by age 65.”
I don’t know about you, but $6.6 million at age 65 sounds great to me.
"How Much Should I Contribute to My 401(k)?"
How much you should contribute is really your personal choice. There are a variety of factors that can impact this choice, but what I would suggest is to at least contribute the minimum percentage needed to get your full employer match, if you are offered one.
Beyond that, you need to consider your current debt, income levels, short and long-term goals, and more. My husband and I chose to contribute the minimum for match until we finished paying off our student loans. We recently bumped my 401(k) contribution up to the maximum per year to use time to our advantage.
The last thing I’ll say about how much is that the standard you set from the start will often dictate your lifestyle. Meaning, if you start contributing 10% from day one, you will learn to life off that amount. If you start contributing nothing, it will be difficult to start contributing later after you’ve developed a lifestyle based on more income now.
"What Type of Accounts Should I Invest My 401(k) In?"
There are three different types of accounts that you can select to direct all or portions of your contributions to as part of your investment account.
- Pre-tax: pay taxes when you make withdrawals in retirement
- Roth: pay taxes when you contribute to the investment account now
- After tax: for the sake of simplicity, I won’t be discussing this option as most plans don’t offer this.
NOTE: Your tax bracket is determined based on your taxable income. Taxable income is your income minus any deductions like charitable giving, dependents, pre-tax contributions and more. If you’re wondering what tax bracket you are currently in, try to estimate your taxable income and check the charts here.
This is the most common option and many accounts default to this if you don’t specify otherwise. If you’re an entry-level in the workplace, finish reading this article, then go check what your investment allocations are. You may need to change yours.
Pre-tax is available for nearly all types of investment accounts and can be a good option for many people, but primarily those who are currently in a higher tax bracket.
Pre-tax contributions lower your taxable income at the time of contribution by opting to pay tax when you take the withdrawal in retirement instead of taxing you when you contribute to your investment account.
This option is most beneficial for someone who is in a high tax bracket now, but expects to be a in a lower tax bracket in retirement. In this case, you would pay less in taxes now while you are at a higher bracket like 28%, 35%, or 39.6%. Instead you would pay the taxes at a lower percentage like 15% or 25% when you take the money out in retirement if you plan to take smaller yearly withdrawals in retirement than you make in income now.
Pre-tax is best for those who make a good income but have a smaller lifestyle than their income – and plan to maintain that lifestyle into retirement. If you’re in your early or mid-twenties, it’s unlikely that pre-tax investing will benefit you unless you make a high income for your age.
This is the best option for most young millennials making entry-level salaries, hands down. If you are at a lower tax bracket than you expect to be in retirement, you should contribute to Roth.
You pay tax on your contributions as you make them, but you will not be taxed when you withdraw them in retirement.
Let’s take an example to make this more understandable.
A single new grad, Brad, starts his first job at $40,000 per year and starts contributing 6% of his salary ($2,400) to his 401k investment account.
Lets assume that Brad’s taxable income is $35,000 after deduction adjustments (charitable giving, dependents, etc). If he contributes his 401K to Roth only, his taxable income would stay at $35,000. If he contributes to pre-tax, his taxable income would drop to $32,600 ($35,000 - $2,400).
Either option would put him in the 15% tax bracket – meaning his taxable income of $35,000 or $32,600 would be taxed at 15%.
As Brad considers what his income would need to be in retirement, he reasons that by the time he retires, an annual income of $75,000 would easily support his lifestyle. Assuming his taxable income each year of retirement is $70,000 after deduction adjustments, his taxable income of $70,000 would be taxed at 25% each year that he takes distributions from his retirement account.
In this scenario, Brad is best suited to continue investing in the Roth option until his taxable income rises to what he expects his retirement distribution income to be later in life. If he contributes to Roth, his taxable income of $32,600 would be taxed at 15% when he contributes versus his taxable income in retirement of $70,000 being taxed at 25% if he contributed to pre-tax.
Let’s fast-forward 15 years in Brad’s life. He’s now making $175,000 per year and is in the 28% tax bracket, with a taxable income of $152,000.
At this point, he should contribute pre-tax instead of Roth if he still plans to have a retirement income of $75,000 per year because he would not be taxed now at 28% of his taxable income of $152,000, but rather he would be taxed when he takes withdrawals at retirement of $75,000 per year and that would be taxed at 25%.