The purpose of a 401K is to help employees save money toward retirement. As employees contribute money toward the 401K, every dollar is tax-deferred (pre-tax). You do not have to pay any tax on your contributions until you take the money out in the future, at which point you will be taxed at your new tax bracket (almost always much lower than now).
A typical 401K plan consists of a/an: employee contribution, employer match, service period requirement for match, vesting policy, and various maximum limits. As you, the employee, contribute a certain percentage of your salary, after you work at the company for a specified period of time, the employer will begin to match your contributions with their set percentage.
Once the money in your account is fully vested (fully owned by you), you may do with it as you please. However, should you take the money out before it is fully vested (at 100%), then you will lose a portion of the matched amount.
Every company differs on contributing & matching percentages, service/employment period requirements and the vesting policy. A company may require a minimum of 3% before it matches anything. It may require a 5% employee contribution before it matches its maximum percentage (let’s say 4%). The percentages vary from employer to employer.
A typical maximum employer contribution is between 3-5%. If your employer matches 5%-6%, PLEASE contribute the maximum allowable yearly amount, as this is excellent matching! Some companies require you to work there for a specified period of time (let’s say 1 year) before you are eligible for employer match. If that is the case, you can still contribute toward the 401K immediately, but will not see a match until your service period is met.
A vesting period is the amount of time you have to work for an employer until your 401K contributions/matches are fully yours for the taking. Company “A” may require 6 years before money is fully vested, while Company “B” may only require 3 years.
Some companies have an immediate vesting policy, meaning that you can do as you please with the money in your 401K immediately. This is an excellent vesting policy. However, this may be a sign of a possible not-so-great match, a long service period requirement for the match, or a very high company turnover. All of these have negative implications.
Some 401K plans have a safe harbor, which limits highly compensated employee contributions and matches. Let’s say a company has a safe harbor of $120,000 for any highly compensated employee who earns over $150,000 per year. In this case, if the employee contributed the maximum 5% of this salary, then the company will match 4% of $120,000 (the safe harbor amount).
The safe harbor amount differs from company to company, so make sure to check the actual number before contributing or accepting employment.
The maximum 401K contribution for 2017 is $18,000 (IRS). Once you turn 55 years old, you may contribute up to an additional $6,000.
Many 401K plans accept qualified rollovers, which allows you to move an already existing 401K account toward the new 401K holder/vendor. Always check with the new vendor whether they accept your plan, as this would eliminate hassle and reduce wasted time in your life.
So, how much should you contribute? Ideally, if you have a good employer match and are committed to staying at a company for a complete vesting period, you should always contribute the maximum possible amount. Not only would you be able to earn up to 6% of your salary, but your taxable income would also drastically reduce.
If you tend to hop from job to job and your company has a lengthy vesting period that you may not meet, still contribute something if you are able as this will reduce your taxable income.
If you do not have money to spare toward a retirement plan right now, contribute the minimum percentage just to get in the habit of living on less. This way, once you begin earning more or if your expenses decrease, adding 1-2 extra percent each paycheck will not make a huge difference in your wallet.