Should you automatically increase your 401(k) contribution rate?


Over the past 30 years, there has been a significant revolution in the administration of 401(k) plans. Often referred to as auto-increase or auto-escalation, here’s how it works: if you’re automatically enrolled in a plan and don’t opt ​​out of the auto-increase feature, your rollover rate will increase over time, until the plan as much as possible. The frequency, rate of increase and maximum of the plan may vary, but a common approach is an annual increase of 1 percentage point on the anniversary of your initial enrollment, up to a maximum of 10%.

According to a 2021 study by the Plan Sponsor Council of America (opens in a new tab), more than half of all defined contribution plans have adopted a self-indexing approach. It has also become increasingly common for plans with a default automatic increase provision to increase your rate beyond what is needed to receive the maximum employer matching contribution. For example, a plan that matches 100% contributions up to 6% of deferred pay might automatically enroll you at 3% and then increase your rate by 1 percentage point per year until you reach a cap of automatic increase of 10%.

Most experts agree that, at a minimum, anyone in a plan offering a match rate of 25% or more should defer enough to receive the plan’s full matching contribution, because this “free money” offers a better rate of return than any alternative. For example, if the plan’s default deferral rate is 3%, but the plan matches 50% of contributions up to 6% of salary, you must (at a minimum) allow any rate increase to have take place at least until the rate of 6% is reached. -eligible deferral rate.

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Is an automatic increase in your 401(k) contributions better?

If you can afford additional savings beyond getting the full employer matching contributions, you may wonder if allowing additional voluntary (unmatched) 401(k) deferrals is the best use of your income. Or should you decline further rate increases to meet other financial needs first?

Unfortunately, you won’t find this issue addressed in most benefit communications. They tend to treat each individual program (medical, dental, life insurance, 401(k), etc.) separately without considering how to allocate your income among the available choices, let alone other financial needs such as debt payment.

This is understandable given the nearly endless number of options available. So how can you decide if the best use of your money is to allow your rollover rate to automatically increase? While it’s not possible to recommend a single course of action, given each individual’s unique circumstances, here are some alternatives to higher voluntary savings that you might also consider.

Build your emergency savings

Financial advisors stress the importance of having a parallel fund to pay for unexpected expenses due to unforeseen events, such as a car accident, storm damage, unreimbursed medical bills, etc. amount you need depends on your annual income, but ideally you should start with at least $1,000 if you have no other savings. And pretax or Roth 401(k) contributions aren’t a good way to save for unexpected expenses for several reasons.

First, if you are under age 59.5, the IRS will only allow in-service withdrawals for certain reasons which may not include emergency expenses. In addition, the taxable portion of any withdrawal made before age 59.5 is subject to 10% excise tax. The IRS also requires that 20% of taxable balances withdrawn – regardless of age – be 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 to help fund these types of savings accounts by allowing you to contribute through regular payroll deductions.

Open a Health Savings Account (HSA)

When a person enrolls in a High Deductible Qualified Health Insurance Plan (HDHP), employers may also offer their employees the opportunity to contribute to a health savings account (HSA) to pay eligible medical expenses on a tax-efficient basis. 401(k) plans and HSAs offer the opportunity to save on a tax-advantaged basis, but the HSA provides additional tax benefits by saving for eligible health care expenses not available in a 401(k) plan under the table below.

The chart compares HSA and 401(k) contributions.

(Image credit: Courtesy of Alan Vorchheimer)

When saving for future health care expenses, most financial experts agree that you should prioritize funding your HSA up to the annual limit before making voluntary contributions to your 401(k) plan. In 2022, you can make HSA contributions up to $3,650 if you have personal coverage or up to $7,300 for family coverage. If you are at least 55 years old, you are entitled to 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 take priority over receiving matching contributions, depending on your tax bracket and matching rate. But if you’re not willing to do a more sophisticated analysis, funding the HSA after securing your full matching contribution is a good rule of thumb.

Pay off credit card debt

A 2021 American Bankers Association survey (opens in a new tab) estimated that over 100 million credit card accounts have a monthly balance. And there is a high cost to carry this debt (opens in a new tab): The average annual effective annual interest rate (APR) for the third quarter of 2022 on interest-bearing credit cards is now 18.43%, and it increases to 22.21% for new card offers.

Based on these numbers, there are probably millions of people who must decide between contributing more to their 401(k) plan or paying off their credit card debt. To help frame this decision, compare current credit card rates to a recent analysis from Fidelity Investments (opens in a new tab) indicating that the average annual return of a diversified investment portfolio over the past 75 years has varied (depending on the level of risk taken) from 5% to 9%.

So, for most people, your credit card debt will grow faster (based on APR) than the assets available to pay it off. This indicates that it is wise to prioritize paying off your credit card debt rather than adding to voluntary savings.

Plus, paying off your credit card debt has the added benefit of lowering your credit utilization percentage (the amount owed to your creditors compared to the maximum credit available) and, therefore, increasing your score. credit. A better credit score not only can you qualify for a lower interest rate and higher credit limits on future borrowings, but can also reduce future insurance rates, as well as the initial deposits required for cell phones, utilities and housing.

Most of the messages we see about retirement plans emphasize the importance of saving and the need to start as early as possible. There is no doubt that adding default provisions to 401(k) plans has advanced these goals. But if you really want to improve your overall financial well-being, consider other forms of savings (including debt elimination) as well as additional voluntary contributions.

This article was written by and presents the views of our contributing advisor, not Kiplinger’s editorial staff. You can check advisor records with the SECOND (opens in a new tab) or with FINRA (opens in a new tab).

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