What is a 401k?

A 401k is a powerful type of retirement account that many companies offer their employees. With each pay period, you deposit a portion of your pre-tax earnings into the account.

It’s called a retirement account because it offers great tax advantages if you don’t withdraw your money until you’re 59 1/2 years old (retirement age).

And there are several benefits to having a 401k account:

Investments before taxes. The money you contribute to a 401k plan isn’t taxed until you withdraw it at 59½, which means you have a lot more money to invest in compound growth. If that money was invested in a normal investment account, part of it goes to income tax.
Free cash with employer match. Most companies offering 401k will match you 1:1 up to a certain percentage of your salary. Let’s say your company offers a 5% match. If you earn $100,000/year and invest 5% of your annual salary ($5,000), your business will match you $5,000, doubling your investment. It’s free money!
Automatic investment. With a 401k, your money is taken from your paycheck and invested automatically, which means you don’t have to log into a brokerage account to invest every month. This is an excellent psychological trick to keep you investing.

Check out the chart below that illustrates why you should always invest in your 401k:

Years	Your contributions	employer combination	Balance without employer remuneration	Balance with the employer’s counterparty
25	$5,000	$5,000	$5,214	$10,428
30	$5,000	$5,000	$38,251	$76,501
35	$5,000	$5,000	$86,792	$173,585
40	$5,000	$5,000	$158,116	$316,231
Four five	$5,000	$5,000	$262,913	$525,826
fifty	$5,000	$5,000	$416,895	$833,790
55	$5,000	$5,000	$643,145	$1,286,290
60	$5,000	$5,000	$975,581	$1,951,161
sixty-five	$5,000	$5,000	$1,350,762	$2,701,525

So a good answer for how much I should have in my 401k is at least enough for the employer to match. And really, there are only two reasons NOT to invest in a 401k:

You are stranded on a desert island and there are no employee benefits.
Your current employer does not offer a 401k.

If your employer offers a compliant 401k plan, call your HR representative and apply as soon as possible.

If your employer DOESN’T offer a 401k plan, apply anyway (but you won’t want to invest in it – check out my video below for more info).

As you do this, you might start to wonder how much you should have in your 401k. And the answer depends on several factors.

How much can you contribute to your retirement account?

As with the Roth IRA, there is a limit to how much you can contribute to a 401k. However, unlike a Roth IRA, you can contribute MUCH more.

As of 2019, you can contribute up to $19,000 a year to your 401k if you’re under 50.

If you are over 50, you can contribute up to $6,000 more, for a maximum of $24,500/year.

Compared to a Roth IRA, where you can only contribute up to $6,000 a year, this is an amazing opportunity. Especially since your pre-tax money accumulates over time.

How much should you contribute to your 401k?

How much you should really invest each month depends on a system I call the Personal Finance Scale. Note three areas:

401k from your employer. Each month, you should contribute as much as necessary to get the most out of your company’s 401k contribution. This means that if your company offers a 5% match, you must contribute AT LEAST 5% of your monthly income to the 401k each month.
If you are in debt. Once you’ve agreed to contribute at least the employer’s contribution to the 401k, you need to make sure you’re not in debt. If not, great! If that happens, fine.
Your Roth IRA contribution. Once you start contributing to your 401k and eliminating your debt, you can start investing in a Roth IRA. Unlike your 401k, this investment account allows you to invest after-tax money and does not collect taxes on your earnings. As of this writing, you can contribute up to $6,000/year.

Once you’ve contributed up to the $6,000 limit to your Roth IRA, go back to your 401k and start contributing beyond the party.

Keep in mind that you can contribute up to $19,000/year to your 401k if you are under 50. So you shouldn’t have any problems continuing to invest in your 401k.

And if you can maximize it, be sure to call me. Let’s go out for a drink with you.

But Ramit, why should I max my Roth IRA before my 401k if it’s so good?

There’s a lot of nerdy debate in the personal finance sphere on this subject, but my position is tax and policy based.

Assuming your career goes well, you’ll be in a higher tax bracket when you retire, which means you’ll have to pay more taxes with your 401k. Also, tax rates are likely to increase in the future.

The personal finance ladder comes in handy when considering what to prioritize when it comes to your investments. For more information, watch my less than three minute video where I explain it.

Balances with vested rights and without funds

The vested portion of your 401(k) plan is the portion you can withdraw if you stop working for the company. You’re always fully committed to the contributions you make to the 401(k) plan, so don’t stop making contributions because you don’t know how long you’ll be with the company. But if you don’t vest when you leave, you could lose some or all of the contributions your employer has made on your behalf.

Acquisition of contributions from the employer

However, your employer may implement an award schedule for contributions made on your behalf, such as matching contributions. However, there is a time limit that the employer can require you to work before fully acquiring you. Each vesting program must be granted at least as quickly as one of the two options.

Cliff’s rewards schedule requires all employees to be fully invested in employer contributions by the end of the third year of employment. The phased award schedule requires employees to have at least 20% of vesting after two years and an additional 20% each year thereafter.

For example, a consolidation schedule that gives employees 10 percent of employer contributions after the first year, and then an additional 30 percent each year thereafter, would qualify because it’s always ahead of the gradual consolidation schedule. However, an entitlement plan that grants employees full after four years but does not grant any entitlements before that point would fail the test because, at the end of the third year, the employee has no vested interests at all, which lags behind both options.