Why should you “max out” your 401(k) or 403(b)?

Should you try to “max out” your company-sponsored retirement plan? Yes.

The 401(k) was created in 1978. Its nonprofit/government counterpart, the 403(b), has been around since 1958. Such plans are the foundation for employer-based retirement plans around Augusta, giving engineers, educators, nurses, physicians, mechanics and most everyone the potential to save for the future. Yet many people don’t realize these plans are one of the most effective ways to build wealth during their working years.

First, let’s discuss what these plans are, and what they are not.

The 401(k) and 403(b) are “qualified” for tax-deferred status by the IRS. In other words, money invested is allowed to “grow” tax free. You only pay income tax when you pull money out – generally during your retirement years, when you will likely be in a lower tax bracket. In comparison, growth and income in “non-qualified” investment accounts are taxed every year.

The 401(k) and 403(b) are not “pension” plans, whereby you receive a “defined benefit” at retirement – usually a fixed, guaranteed payment based on your salary and years of service. This is why 401(k)s and 403(b)s are referred to as “defined contribution” plans, since the money is based on your contributions, the investment choices you make, and how much your employer gives in “matching "contributions (companies often provide a dollar-for-dollar match up to a limit – usually between 3% to 6% of the employee’s compensation).

Defined contribution and defined benefit plans each have pros and cons, but traditional pensions are becoming increasingly rare, making 401(k)s and 403(b)s the primary retirement vehicle for wage earners.

How can you get the most “bang for the buck” from your plan?

First, shovel as much money as possible into your plan. Under current tax law, workers under 50 are allowed to contribute up to $23,000 a year. Those over age 50, are eligible for $7,500 “catch-up” contributions, bringing the maximum to $30,500.

Why should you try to “max out” contributions? The obvious reason is to have more money in retirement. But there is also the benefit of lowering your taxes. That’s because 401(k) and 403(b) contributions are made “pre-tax,” meaning every dollar saved reduces your taxable income by an equal amount. Not only will you owe less income tax, you may also reduce the likelihood of exceeding income thresholds for benefits such as tax credits and financial aid for your kids’ college expenses.

So, if you are a high earner who can afford to “max out,” there is little reason not to! In fact, some employers even allow additional non-deductible after-tax contributions that can be rolled into a Roth IRA (often called a "back door” Roth contribution), thus allowing your money to grow even more in a tax-qualified way.

If you are a lower-income worker who might not be able to save as much, try to at least contribute as much as your employer is willing to match to take advantage of what is essentially “free money.” Making a 3% contribution in a plan that offers a 3% match, for example, is an immediate 50% return on the investment – an excellent return by just about any standard.

One thing to remember about 401(k)s and 403(b)s is that you are in control of how the money is invested, so it’s important to adjust (“rebalance”) investments as you get closer to retirement.

Generally, younger workers with time on their side can afford to choose more “aggressive” plan options, while older employees may want to focus contributions in more “moderate” investments to protect their savings as they get closer to retirement. Plan options vary widely by employer.

Many 401(k) and 403(b) plans also have a Roth component, in which contributions are made after you’ve already paid taxes on the income. Although Roth contributions don’t reduce your taxable income, you do get the benefit of tax-deferred investment growth and the benefit of tax-free distributions in retirement.

Regardless of whether you are maxing out your 401(k) or 403(b), or contributing just enough for the employer match, what you do not want to do is pull money out prematurely. Generally, withdrawals before age 59 1/2 can result in income tax on the distribution, but also a 10% IRS penalty (with certain exceptions for major life events, such as buying your first home or becoming disabled).

Should you leave your employer – or exit the workforce entirely – you have the option to keep your 401(k) or 403(b) money in the plan or “roll it” tax-free into another qualified plan or an IRA. As with most financial decisions, there are pros and cons to “leaving it” or “rolling it.”