Under federal tax rules, 401(k) plans are classified as tax-qualified accounts, which means that your plan grows on a tax-deferred basis. Many people attempt to take advantage of these tax savings by investing as much as they can into their 401(k) plans. However, your contributions are subject to annual limits, and once you invest your money you may have to pay a hefty penalty to access it again. You should carefully consider your short-term and long-term needs before you decide how much to invest in your plan.
Generally, you cannot access the money that you deposit in your 401(k) until you leave your job. The Internal Revenue Service allows your employer to include a clause in your plan that allows participants to remove funds when faced with certain financial hardships. However, if you make a hardship withdrawal before you reach the age of 59.5, you have to pay a 10-percent tax penalty as well as regular income tax. Before investing in your plan, you should determine how much money you need to cover basic expenses such as your mortgage and groceries. Allow yourself a little bit of extra money to cover unexpected costs and consider investing whatever remains of your salary into your 401(k). Do not invest money that you think you may need prior to leaving your job or retiring.
Some people elect to invest their funds into individual retirement arrangements (IRAs) rather than 401(k) plans because employer-sponsored plans have limited investment options. However, before you decide how much to invest in your 401(k) or IRA, you should find out if your employer offers a company match. Employers can match your contributions up to 6 percent of your salary. If you make $50,000 a year and deposit $3,000 into your 401(k) each year, then a company matching contribution means that an amount equal to 12 percent of your salary, or $6,000, goes into the account every year. Therefore, take full advantage of company matches without investing so much money that you cannot cover your day-to-day costs. IRAs give you more investment options, but you do not get a company matching contribution.
As of 2011, you can make an annual contribution of up to $16,500 into your 401(k) if you are younger than 50, while older employees can deposit up to $22,000. If you have a high income level you may consider making the maximum contribution, but IRS rules pertaining to highly compensated employees may prevent you from doing so. If you earn more than $110,000 per year, IRS rules prevent you from contributing a higher percentage of your salary to the account than the less well-paid employees at your firm. If other employees contribute just a small percentage of their salaries to the plan, then your contributions are also limited.
When you determine how much you can afford to invest in your 401(k), you should take into account your future financial needs as well as your current needs. When you retire you may have to heavily rely on your 401(k) for your retirement income. Economists expect the Social Security Administration to run short of funds in the coming decades, which means you cannot rely on the government to provide you with a retirement income. If you reduce your discretionary spending by eliminating magazine subscriptions, lunches at expensive restaurants and other costs, then you can afford to invest more money into your 401(k). A company matching contribution means you double your money for every dollar you save, and you may thank yourself for cutting your spending when you actually retire.