What Is the Right Amount to Contribute to a 401(k) in the USA?

IRS tax code section 401 and sub section k outlines the rules to allow employees to elect to defer a portion of their compensation. This deferred income is not subject to federal income tax at the time of deferral. The money in 401k can be invested in the market and the gains and contributions are taxed only when we withdraw during the retirement (after 59 and half years). Employers may contribute some amount to employees 401k as well.

In this article, we will discuss the below topics.

• What is the right amount to contribute to 401k?
• Why it's not a good idea to max out your 401k as first choice.

What is the right amount to contribute to 401k?

We should contribute to your 401k enough to get the maximum employer contribution. Let's take one common employer match option. Employer match 50% of the first 6% employee contribute. For example, if you are making 100k and contributing 6% to your 401k, the calculation goes like below.

Salary : 100k
Your contribution of 6% : $6000
Employer contribution (50% of first 6%) : $3000

Imagine you contribute only 5%, then the calculation go like below

Salary : 100k
You contribution of 5% : $5000
Employer contribution (50% of first 6%) : $2500

In the second example, you are missing out $500 free money from your employer. So, you need to contribute minimum 6% to get the maximum employer contribution.

Why it's not a good idea to max out your 401k as first choice.

The 401k account is tax deferred account. While putting money in, we will get tax exemption and while taking out in retirement, we will pay taxes. It's beneficial if the tax rates are going to go down in future or we will be in lesser tax bracket in retirement. There are two problems for this to be true. Currently , the tax rates are on the lower side, and the country's debt is all time high (33 trillion as of year 2023).

So, what do you think? Will the taxes be high or low in future?

Also, look at major tax deductions we take in working years.

Home mortgage interest

401k contribution

Child tax credit

Charitable donations

During retirement we will not have first three. For the fourth one, If we are doing charitable donations now, mostly we will continue during retirement as well. But instead of money, we might contribute more time. What does IRS think about our time? Is it tax deductible? Unfortunately, NO. We will not have any major tax deductions in retirement and the general tax bracket might be high. We will just have standard deduction. So, in retirement while doing 401k withdrawal, you might pay more taxes than the benefits you got while putting in money. You might say, I will only take enough from 401k to stay in the lower tax brackets. That's a good point. But your tax will be based on total income i.e., the money you get from social security, any pension plans, any rental income, and income from any other investments. All these together can easily put you into higher tax bracket. Also, at certain age the RMD (Required minimum distributions) kick in and you will be forced to withdraw money from 401k. Remember, IRS hasn't taken the tax on this money yet and they want to take it before we die. So, they enforce RMDs after certain age into retirement.

The strategy should be first do the employer match, then go for Roth IRAs and 401k Roth. After that, you can debate whether to max out 401k. In Roth IRA and 401K Roth, you will pay taxes now and will not pay taxes when you withdraw during your retirement.

That's a wrap this week. Happy Learning!

Please note that I am not a financial advisor or tax consultant. I write based on my own research, experiences gained doing these things, and interviewing the people done these things. So, be aware of the options and discuss with your tax consultant to make right decisions for your financial situation.