If you’ve been following the ongoing debate in Washington about tax reform, you are probably aware that policymakers considered changes to 401(k) plans, specifically how much an individual can contribute pre-tax in any given year.
A 401(k) is a retirement savings plan that can be offered as a benefit by your employer. It lets workers save and invest a portion of their paycheck before taxes are taken out. It allows savings to grow tax-deferred, as taxes aren’t incurred until the money is withdrawn from the account. And many 401(k) plans come with an “employer match,” which is money that a company contributes to an employee’s 401(k), based on the contribution from the employee. While companies are not required to offer this benefit, many companies use their match as a way to attract talent and to encourage employees to save for retirement.
While not everyone has access to a 401(k), it’s estimated that more than 50 million workers across the U.S. are actively participating in the 401(k) plan offered by their employers.
These retirement savings plans have become increasingly important over the last few years, especially as fewer employees have access to a pension plan. For many Americans, especially younger workers, that means the 401(k) has become one of the primary vehicles for their retirement savings. While Social Security and personal savings will also figure into an individual’s retirement scenario, the 401(k) is generally one of the biggest contributors to retirement savings for a big part of today’s workforce.
Participation in 401(k) plans has reached record levels, as has the average amount workers are contributing. Employers are steadily increasing the average company match, and making more education materials available to their workers to help them understand their 401(k) and make good decisions based on their individual situation.
Combining those efforts with strong economic conditions over the last few years, the average 401(k) account balance is the highest it has ever been and more than double the average balance during the financial downturn in 2008-2009.
These are all positive indicators, but there is still work to be done. While the average contribution rate has improved, it is still short of Fidelity’s 15 percent rule of thumb savings rate (which includes both employer and employee contributions). While participation rates are up, more than one in four workers who are eligible to participate in their company’s 401(k) have not enrolled. Part of the success of the 401(k) is that it allows workers to accumulate savings over many years — and not participating, even for just a couple of years, can make it harder for workers to save enough money to enjoy the retirement lifestyle they are hoping for.
So considering the current state of the 401(k), how would changes impact workers’ ability to save for retirement? What should you do if pre-tax 401(k) contributions are limited in the future?
First, the important thing is that it is still wise to continue saving. The 401(k), and any contributions from your employer, can still be a great way to put aside money for retirement.
Second, if pre-tax contributions are limited in the future, consider an Individual Retirement Account, or IRA. These accounts are similar to 401(k) accounts, and depending on your modified adjusted gross income you may be able to deduct your contributions from your taxes and your money grows tax-deferred (but will be taxed once you withdraw it from your account).
The annual contribution limit for IRAs is $5,500 per tax year, so even if pre-tax 401(k) contributions are capped in the future as part of tax reform, contributing to both a 401(k) and IRA can help the average worker keep their retirement savings efforts on track. There are also Roth IRAs that are funded with after-tax contributions and offer tax-free growth potential.
The conversation around tax reform is very fluid, and several different 401(k)-related proposals are still on the table. However, most recent reports suggest that 401(k)s will stay the same for the time being.
At Fidelity, we often remind our customers that saving for retirement is a marathon, not a sprint, and a variety of factors will shift and change between now and your retirement day. Regardless of the outcome in Washington, San Diegans can continue to turn to their 401(k) as a savings vehicle, and continue to take proactive steps to ensure they are able to enjoy the retirement lifestyle they want.
Stoner is a vice president at Fidelity Investments, leading the firm’s Rancho Bernardo Investor Center.