Over the past 30 years, there has been a significant revolution in the administration of 401(k) plans. Often called auto-escalation or auto-escalation, this is how it works: If you are automatically enrolled in the plan and do not opt out of the auto-escalation feature, then your deferral rate will increase over time, up to the maximum plan. frequency, the rate of increase and the maximum plan may vary, but the general approach is an annual increase of 1 percentage point in your initial re-enrollment, up to a maximum of 10%.
According to a 2021 study by The American Council Sponsorship Plan (opens in new tab), more than half of all defined contribution plans have adopted the auto-escalation approach. It has also become more common for plans with a standard automatic increase provision to increase your level above that required to receive the maximum employer matching contribution. For example, a plan that matches 100% of contributions up to 6% of deferred salary may automatically enroll you at 3% and then increase your rate by 1 percentage point per year until you reach the 10% automatic increase cap.
Most experts agree that, at a minimum, all participants in plans that offer a matching rate of 25% and above should delay enough to receive the plan’s matching contributions, because this “free money” provide a better rate of return than any alternative. For example, if the plan’s standard deferral rate is 3%, but the plan matches 50% of contributions up to 6% of salary, you should (at a minimum) allow any rate increases at least until you reach the 6% match. – eligible deferral rate.
Are Automatic Increases in Your 401(k) Contributions Best?
If you can afford additional savings beyond getting full employer matching contributions, you may be questioning whether making additional voluntary (unmatched) 401(k) deferrals is the best use of your income. Or should you opt out of the next level upgrade to address other financial needs first?
Unfortunately, you won’t find this issue addressed in most benefits communications. They tend to treat each individual program (medical, dental, life insurance, 401(k), etc.) separately without thinking about how to allocate your income among the available options, let alone consider other financial needs such as pay the debt.
This is understandable given the almost infinite number of options available. So, how can you decide if the best use of your money is to allow your deferral rate to automatically increase? While it is impossible to recommend a single course of action, based on each individual’s unique circumstances, here are some alternatives to higher voluntary savings that you may also consider.
Build Your Emergency Savings
Financial advisors stress the importance of having a side fund to pay for unplanned expenses due to unexpected events, such as car accidents, storm damage, unpaid medical expenses, etc. the amount you need depends on your annual income, but ideally you will start with at least $1,000 if you have no other savings. And pretax or Roth 401 (k) contributions are not a good way to save for unexpected expenses for several reasons.
First, if you’re under age 59½, the IRS will allow in-service withdrawals only for reasons that don’t include emergency expenses. Further, the taxable portion of any withdrawal before age 59½ is subject to a 10% excise tax. The IRS also mandates that 20% of the taxable balance withdrawn – regardless of age – is withheld for federal income tax.
Consider building emergency savings in a separate account outside of your 401(k) plan. Employers are starting to offer their employees help to fund this type of savings by letting you contribute through regular payroll deductions.
Open a Health Savings Account (HSA)
If a person enrolls in a qualified health-deductible health plan (HDHP), employers can also offer their employees the ability to contribute to a health savings account (HSA) pay qualified medical expenses on a tax-advantaged basis. Both 401 (k) plans and HSAs offer the ability to save on a tax-preferred basis, but HSA has additional tax benefits in saving for qualified health expenses not available in 401 (k) plans per the chart below.
In saving for future health care expenses, most financial experts agree that you should prioritize your HSA funding up to the annual limit before making voluntary contributions to your 401(k) plan. In 2022, you can make HSA contributions of up to $3,650 if you have independent coverage or up to $7,300 for family coverage. If you are at least 55 years old, you are allowed an additional $1,000 in annual catch-up contributions.
There is even a school of thought that the tax benefits of an HSA are so valuable that they should be prioritized instead of receiving matching contributions, depending on your tax bracket and the matching rate. But if you’re not willing to do a more sophisticated analysis, funding your HSA further after receiving your matching contributions is a good rule of thumb.
Paying Down Credit Card Debt
A 2021 survey by the American Bankers Association (opens in new tab) It is estimated that more than 100 million credit card accounts carry a monthly balance. And there is a high cost to bear that debt (opens in new tab): The-third quarter of 2022 average annual percentage interest rate (APR) on credit cards accruing interest is now 18.43%, and this rises to 22.21% for new card offers.
Based on these figures, there are likely millions of people who have to decide between contributing more to their 401(k) plan or paying down their credit card debt. To help frame that decision, compare current credit card rates latest analysis by Fidelity Investments (opens in new tab) indicates that the average annual return of diversified investment portfolio over the past 75 years varied (depending on the level of risk taken) from 5% to 9%.
So, for most people, your credit card debt will pay off faster (based on the APR) than the assets available to service it. This suggests that it is wise to prioritize paying down your credit card debt instead of adding to voluntary savings.
Furthermore, Paying down your credit card debt has the added benefit of lowering your credit utilization percentage (the amount owed to your creditors compared to the maximum available credit) and, in turn, raising your credit score. A better credit score not only can qualify you for a lower interest rate and a higher credit limit on future loans, but potentially lowers future insurance costs, as well as reducing all upfront deposits required for cell phones, utilities and housing.
Most of the messages we see about retirement planning emphasize the importance of saving and the need to start as soon as possible. There is no doubt that adding standard provisions to 401(k) plans has furthered their goals. But if you want to improve your overall financial wellness, consider other forms of savings (including debt relief) as well as additional voluntary contributions.