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How Much Should I Contribute to My 401(k)?

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How Much Should I Contribute to My 401(k)?

The recent tax cut bill signed into law by President Trump is reducing corporate taxes significantly as well as lowering the marginal tax rates for most of the taxpayers. With these significant changes, the 401(k) has increased its maximum contribution amount to $18,500 (from $18,000 in 2017) with a Catch-up provision of $6,000 (same as 2017). Contributing this amount to your 401(k) can certainly help you reach your retirement goals, but are there better ways to do this?

Retirement assets, which include defined contribution plans such as IRAs and 401(k)s and defined benefit plans such as pension funds, total $27.2 Trillion in the US. $7.7 Trillion of this is in employer-based defined contribution plans, with $5.3 Trillion in 401(k) plans). 401(k) plans hold 19% of all retirement assets, and this is up from 17% in 2007. Retirement assets represent 35% of all financial assets held by households in the United States.

Many people have put most of their family savings into these plans. But there may be problems that result from this strategy.

Access to Cash

The number one issue is that of liquidity. Your 401(k) plan has limits on access that could cause you to incur tax and penalties if you were to withdraw from the account. Although most participants are committed to saving and do not access their plans early, a loss of a job, disability or another family emergency could disrupt this commitment. It makes sense to develop an emergency fund first before trying to maximize your 401(k) plan contributions.

Also, think of the cost of maximizing your contribution while at the same time taking on personal debt, such as car loans or credit card debt, to make ends meet. Putting yourself in debt as a way to maximize your plan contribution doesn’t make long-term financial sense.

Saving Tax?

Next, while it may be exciting to see your 401(k) plan grow, you have to realize that your taxes have been merely deferred into the future. It is impossible to say today what amount of that value will ultimately be yours. You have a silent partner in your plan – that partner is the U.S. Government, and it wants to be paid eventually. When you are ready to retire, every dollar you withdraw will be subject to income taxes – but no one knows today what that ordinary income tax rate will be. The key here is to remember that “tax deferral” is not the same as “tax savings.” Any savings depends on what tax rate you will be at in the future.

Having multiple sources of financial assets is part of a sound financial strategy. Contributing to a 401(k) plan is advisable, and especially up to the point of your company match. But first, be sure to have adequate and liquid reserves to weather an emergency and then diversify your savings plan to include after-tax solutions to complement the traditional tax-deferred savings plan.

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