Contributing consistently to your 401(k) and investing the money is one of the most effective ways to build wealth and ensure a comfortable retirement for yourself. Although retirement may seem far away, as we’ve discussed repeatedly, through the power of compound interest, starting early and consistently will pay off greatly in the long run. Depending on your goals for retirement you may be able to invest less per month if you start earlier, or you can end up with a much larger retirement fund if you decide to contribute aggressively. Let’s discuss some essential tips to help you maximize your 401(k) and set yourself up for financial success.

1. Understand the Different Types of 401(k)s

The first thing you’ll want to understand is the difference between the various types of 401(k) plans. There are a few types of 401(k) plans but some are only relevant if you own your own business, so we won’t cover those.

The two main types of plans that most people will encounter are the Traditional 401(k) and Roth 401(k). They each come with their own benefits and trade-offs, but the main difference comes down to how they are treated for tax purposes. For both types of accounts, generally, you will need to wait until you are at least 59 ½ years old to make withdrawals without incurring penalties.

Traditional 401(k) 

• Contributions are made using pre-tax dollars, which means you’ll get a tax deduction for the year and reduce your taxable income. 
• Investments will continue to grow tax-deferred, which essentially means that you won’t pay taxes on any of the money, including the gains until you withdraw from your 401(k) during retirement. 
• This can help you save a significant amount on your taxes in your working years and is especially powerful during your highest earning years.

Roth 401(k)

• Contributions are made with after-tax dollars, so you won’t get any immediate tax breaks. 
• Investments will grow completely tax-free and withdrawals during retirement are tax-free as well. However, you must have had your account open for at least 5 years in order to make penalty-free withdrawals.
• This can be beneficial if you have a long period to compound your money and if you are currently in your lower earning years.

2. Choose your 401(k) type wisely

While the choice between a Roth and Traditional 401(k) is not super straightforward, here are some general guidelines to follow:

• If you expect to be in a higher tax bracket during retirement, you should be contributing to a Roth 401(k). This is typically the case if you are younger since you are likely not at the peak earning years of your career. 
• If you expect to be in a lower tax bracket during retirement, you should be contributing to a Traditional 401(k).
• As well, if you are young your money has a lot more time to compound, so the tax-free withdrawal treatment of a Roth 401(k) can be very valuable. For young people, it typically makes sense to contribute to a Roth 401(k).

Ultimately, it’s very hard to predict future tax conditions so for younger people in general a Roth 401(k) is a good choice, but you could also consider investing in a Roth 401(k) as well as a Traditional IRA, or vice versa to diversify the tax treatments of your investments. You can also use an online calculator to compare the options.

If you end up contributing to a Traditional 401(k) it’s also wise to invest the tax savings that you get from contributing to a Traditional 401(k). This is because the Roth 401(k) option essentially forces you to invest those tax savings you would’ve got, whereas with the Traditional 401(k) its possible to spend those tax savings instead.

3. Start Early and Contribute Consistently

Optimizing for the best type of account means nothing if you aren’t consistently contributing to your account and investing wisely. Make sure that you allocate some amount of every paycheck to your 401(k). Contributing just $500 a month for 40 years means you will have over $1.5 million. If you were contributing to a Roth 401(k) that $1.5 million would be completely tax-free and you would be able to retire. However, if you start contributing 10 years later, $500 a month for 30 years would result in $680,000, a far cry from $1.5 million. Be sure to start early and invest consistently. It takes a lot of discipline and dedication, but your future self will be truly grateful.

4. Take Full Advantage of Employer Matching

Make sure to research your employer match fully. This is one of the only times you’ll get free money and you should take full advantage. The way your employer matches contributions will vary by employer, but typically they’ll match some percentage of your contributions, up to a yearly cap based on your salary. However, make sure that you fully understand how your employer match works, as certain companies may only match up to a certain amount every paycheck, so if you max out your 401k early you might be leaving money on the table.

If you take advantage of the employer match every year for many years, it can quickly start to grow and snowball. This combined with the tax-advantaged nature of the 401k will eventually mean that you’ll have a very large sum of money during retirement.

4. Understand Your Investment Options

Usually, the investment options in your 401(k) plan are pretty limited and are dictated by your employer. This is typically good for most people since it prevents people from investing in individual stocks and losing a lot of money. Investments can range from target-date retirement funds to small-cap and large-cap funds. If you want to pick an investment and never think about it again, a target-date retirement fund can be good. Or you can try to find a total market index fund or S&P 500 index fund, which are good options for long-term investors. 

The main thing to be wary of is high expense ratios. Target-date retirement funds may have a higher expense ratio than a simple total market index fund. And these expense ratios add up over time and can greatly impact your long-term gains. So choose wisely and aim for lower expense ratios.

5. Increase Contributions Over Time

You may not be able to max out your 401k at first but aim to contribute enough to at least max out your company match. When your income increases over time, make sure you are contributing some of that increased pay to your 401k. Many people make the mistake of increasing their spending every time they get a raise.

While you can certainly treat yourself and increase your spending, be sure to consistently invest and even automate the process by automatically contributing a certain percentage of your income to your 401k. By setting aside money to invest before everything else, you won’t fall into the trap many people fall into of spending first and then having no money left to invest at the end of the month.

Increasing your contributions incrementally can have a significant impact on your retirement savings without drastically affecting your current lifestyle. If you receive a 5% raise, you might allocate half of that increase to your 401k and the remaining half for other expenses. This approach allows you to steadily build your retirement fund while also enjoying some of your income growth.

Conclusion

Maximizing the benefits of your 401(k) is a critical component of building a secure financial future. By starting early, taking full advantage of employer matching, understanding your investment options, and contributing consistently, you can make the most of your 401(k) and ensure a comfortable retirement. Make sure you’re investing in low-cost funds, increase contributions over time, and avoid early withdrawals to keep your retirement savings on track. With these tips, you’re securely on track to achieving financial independence and a comfortable retirement.

Disclaimer: The content provided on this blog (Zooming to Fire) is for informational and educational purposes only. It represents the opinions and perspectives of the authors and should not be considered as financial advice. The authors are not licensed financial advisors, and no content on this blog should be in any way interpreted as professional financial counsel or advice. See more here.