5 ways to maximize your retirement contributions
Here are five steps to get you there, listed in order of priority -- start with No. 1 and move through the list as your income increases.
1. Take Full Advantage of Your Employer Match
First and foremost, find out how an employer match works in your 401(k). Typically, your employer will match your own contributions up to a certain limit, stated as a percentage of your salary or a dollar amount. Know what that limit is, then set up your contributions so you're getting the maximum. These employer-funded contributions are free money, and they're one of the simplest ways to generate savings momentum.
2. Don't Switch Jobs Unless You Are Fully Vested
Most 401(k) plans have vesting rules for company-match contributions. These rules define how long you must stay with the company before you fully own those employer-funded deposits. For example, the plan rules might state that your ownership increases by 20% each year you're with the company. Under those rules, you'll own 20% of the matching contributions after one year, 40% at the end of the second year, 60% after the third, 80% after four years and 100% after five.
Consider the cost of losing those contributions before you decide to switch jobs. Let's say you made $70,000 in your first year with your employer and the maximum company match is 3%. Assuming you got the full company match from the first day, your 401(k) balance after one year includes $2,100 in employer-funded contributions. If you leave when you're only vested to 20%, you own $420 of that $2,100. Taking a different job means you walk away from the remaining $1,680, plus any earnings from those funds.
If your new job offers a substantially higher salary, it may be worth it to walk away from your company-match contributions. Just make sure you make a sizable increase to your contribution rate at the new job, to offset the funds you left behind.
3. Max Out Your HSA
After maxing out your company match, start contributing to a health savings account (HSA) if you're eligible. HSAs are available to anyone enrolled in a high deductible health plan, defined as a health insurance plan with a minimum deductible of $1,400 for an individual or $2,800 for a family.
Use the HSA as a long-term investment account, and it becomes a crucial piece of your retirement portfolio. Just like your 401(k), you contribute to the HSA with tax-free dollars, and you can invest those contributions, with the earnings in the account growing tax-free. But here is the standout feature of your HSA: You can take tax-free withdrawals for qualified medical expenses. And there's little risk of overcontributing, either.
Once you turn 65, withdrawals for non-qualified expenses are taxed at your normal income tax rate, just as they would be for your 401(k).
2020 HSA contribution limits are $3,550 for individuals and $7,100 for families. If you are 55 or older, you can contribute an additional $1,000.
4. Max Out Your 401(k) Contributions
Once you've maxed out your company match and your HSA contributions, the next step is to start ramping up your 401(k) contribution rate. Keep funneling more money into that account until you hit the maximum contribution mandated by the Internal Revenue Service.
In 2020, you can contribute up to $19,500 to your 401(k), plus an additional $6,500 if you're 50 or older. Employer-match contributions do not count toward those limits, but there is a cap on total 401(k) contributions. In 2020, the sum of your contributions plus your company-match contributions cannot exceed $57,000 ($63,000 if you're 50 or older).
5. Do the Same With IRA Contributions
At this point, you've maxed out a company match, HSA contributions, and your own 401(k) contributions. What's left? You can still make contributions to an IRA. The cap on Roth and traditional IRA contributions is $6,000, or $7,000 if you're 50 or older.
Roth IRA contributions are not tax-deductible and are subject to limits on your modified adjusted gross income (AGI). Single tax filers with income greater than $139,000 cannot make Roth IRA contributions .
Traditional IRA contributions have no income limits, but your contribution may not be tax-deductible. If you are also covered by a 401(k) at work, the tax deduction gets phased out at certain income levels. Single tax filers who also have a 401(k) can get a tax deduction on traditional IRA contributions if their income is $65,000 or less. No tax deduction is available for single tax filers who make $75,000 or more.
Even if you don't qualify for a deduction, your IRA contributions still grow tax-free -- and that is a perk worth using. Once you reach the age of 59 1/2, you can withdraw your IRA funds without penalty. Traditional IRA withdrawals are subject to income tax, and Roth IRA withdrawals are not.
The safest road to your ideal retirement is to save now and hit those max contribution limits as soon as possible. Stay on that course for the long haul and watch your nest egg grow.