During the past 30 years, there has been an important revolution in the management of the 401(k) scheme. Often referred to as auto-increment or auto-escalation, here’s how it works: If you’re automatically enrolled in a plan and don’t opt out of the auto-increment feature, the deferral rate will increase over time, up to the max plan. The frequency, rate of increment, and plan maximum can vary, but the common approach is an annual increment of 1 percentage point on the anniversary of your initial enrollment, up to a maximum of 10%.
According to a study conducted in 2021 by The plan sponsor is the Council of America (Opens in a new tab), More than half of all defined contribution plans have adopted an automatic escalation approach. It’s also becoming increasingly common for plans that include a default automatic raise to increase your rate above what is required to receive the maximum matching employer contribution. For example, a plan that matches 100% contributions up to 6% deferred payment might automatically score you 3% and then increase the rate by 1 percentage point per year until you reach an automatic 10% increase cap.
Most experts agree that, at a minimum, everyone who participates in a plan offering a matching rate of 25% and above should defer long enough to receive the full matching plan contribution, because this “free money” It provides a better rate of return than any other alternative. For example, if the plan’s default deferral rate is 3%, but the plan matches 50% contributions up to 6% pay, you must (at a minimum) allow any rate increase at least until you reach the matching 6% deferral rate qualification.
Is an Automatic Increase in Your 401(k) Contributions Best?
If you can afford additional savings beyond getting your full matching employer contributions, you may be wondering if allowing additional voluntary (unmatched) 401(k) deferments is the best use of your income. Or should you opt out of additional price increases to meet other financial needs first?
Unfortunately, you won’t find this issue addressed in most feature 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 options available, let alone taking into account other financial needs such as pay debts.
This is understandable given the almost infinite number of options available. So, how do you decide if the best use of your money is to allow the deferral rate to increase automatically? While it’s not possible to recommend a single course of action, given the unique circumstances of each individual, here are some alternatives to higher voluntary savings you might consider as well.
Build your emergency savings
Financial advisors stress the importance of having a side fund to pay for unplanned expenses due to unforeseen events, such as car accident, storm damage, unpaid medical expenses, etc. Quantity you need Depends on your annual income, but it’s best to start with at least $1,000 if you don’t have other savings. And pre-tax or Roth 401(k) contributions aren’t a good way to save for unexpected expenses for several reasons.
First, if you are under 59, the IRS will only allow in-service withdrawals for certain reasons that may not include emergency expenses. Furthermore, the taxable portion of any withdrawal prior to the age of 59½ is subject to a 10% excise tax. The IRS also mandates withholding 20% of taxable balances withdrawn—regardless of age—for federal income taxes.
Consider building emergency savings in a separate account outside of your 401(k) plan. Employers have begun to help their employees fund these types of savings accounts by allowing you to contribute through regular payroll deductions.
Open a Health Savings Account (HSA)
When someone enrolls in a qualified high-deductible health plan (HDHP), employers may also offer their employees the ability to contribute to Health Savings Account (HSA) To pay for eligible medical expenses on a preferred tax basis. Both 401(k) plans and HSAs provide the ability to save on a preferred tax basis, but the HSA has additional tax benefits in saving for eligible health care expenses not available in a 401(k) plan as per the chart below.
When saving for future health care expenses, most financial experts agree that you should prioritize HSA financing 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 self-only 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 compensatory contributions.
There is even a school of thought that HSA tax benefits are so valuable that they should be prioritized over receiving matching contributions, depending on your tax bracket and matching rate. But if you’re not up for a more complex analysis, financing an HSA after getting your full matching contribution is a good base.
Pay off credit card debt
2021 Survey by the American Bankers Association (Opens in a new tab) It is estimated that more than 100 million credit card accounts have a monthly balance. A file A high cost to bear this debt (Opens in a new tab)The average annual interest rate (APR) for the third quarter of 2022 on accrued credit cards is now 18.43%, and that ratio rises to 22.21% for new card offerings.
Based on these numbers, there will likely be millions of people who have to choose between contributing more to their 401(k) plan or paying off credit card debt. To help frame this decision, compare current credit card rates to Recent analysis by Fidelity Investments (Opens in a new tab) Which indicates that the average annual return for a diversified investment outlet over the past 75 years has varied (depending on the level of risk) from 5% to 9%.
So, for most people, your credit card debt will grow faster (based on the APR) than your serviceable assets. This suggests that it is wise to prioritize paying off your credit card debt over adding to voluntary savings.
Furthermore, paying off your credit card debt has the added benefit of lowering your credit utilization ratio (the amount owed to your creditors compared to the maximum available credit), thus raising your credit score. a Better credit score Not only can it qualify you for a lower interest rate and higher credit limits for future borrowing, but it will likely lower insurance rates in the future, as well as reduce any pre-deposit required for cell phones, utilities, and housing.
Most of the messages we see about retirement plans emphasize the importance of savings and the need to get started as soon as possible. There is no doubt that adding hypothetical provisions to 401(k) plans has furthered these goals. But if you really want to boost your overall financial wellness, consider other forms of savings (including debt cancellation) in addition to additional voluntary contributions.