Thinking about retirement planning? If so, you’re probably wondering, “How much should I contribute to my 401(k)?”
These employer-sponsored retirement accounts are a great way to save for retirement. The traditional 401k offered by most employers, allows you to contribute pre-tax dollars. You avoid taxes now, but you get hit with a tax bill in retirement. But, as with any financial questions, there really aren’t any one-size-fits-all answers. Many personal factors affect how much money you’ll need in retirement, and more specifically, how much you should be putting into your 401(k) account.
To point out just some of the most significant:
- How old are you?
- When do you hope to retire?
- What other income, savings, and assets will you have in retirement?
- Are you married, and will your spouse have any savings or income?
- What will your predictable costs of living be in retirement?
- What sort of lifestyle do you want to have in retirement?
- Might you have elderly parents who need costly care?
Here’s some general information about figuring out what to do with your 401(k). Remember though, this is no substitute for tailored advice from a professional financial adviser. You can always contact us if you need such advice.
Get Every Dollar Possible From Your Employer
The easiest 401(k) advice to give is that you should at least contribute the full amount that your employer will match. Often, your employers will contribute $1 for every dollar you save, up to 3 percent of your salary; or, your employer will contribute 50 cents for every dollar you save, up to 6 percent of your salary.
In these examples, you get a 100 percent of 50 percent return on your investment. In the second example, if you make $50,000 per year, you’d be contributing $3,000 and your employer would be contributing $1,500 annually; you’re saving $4,500 per year, or 9 percent of your salary.
It’s literally free money. Don’t pass any of it up.
Be Mindful of the Contribution Limit
There is an annual cap on 401(k) contributions that you can’t exceed although your employer’s contributions don’t count toward the cap. In 2018, the limit is $18,500, or $24,500 if you’re 50 or older.
That’s a considerable amount. If you save $18,500 for 35 years and average a 6 percent annual return, your 401(k) will be worth around $2.2 million at retirement. And that doesn’t include employer contributions.
If you want to save more money than you can put into a 401(k), an IRA is another good option, though it will have considerably lower annual contribution limits ($5,500 for people under 50 and $6,500 for people 50 and older in 2018). Read up on choosing between a traditional and a Roth IRA.
Saving a Percentage of Your Income
Many experts recommend saving at least 10 percent of your annual income in a 401(k) and/or other retirement accounts. In many instances, this is a good baseline to aim for. However, it’s much more practical for people who start saving when they’re relatively young. Very generally speaking, the 10 percent figure is best suited to individuals in their 20s. By your 30s, 15 percent is a safer minimum, and by your 40s, 25 percent or more is often needed to reach typical retirement goals.
These considerations are one area where the personalized advice of a professional financial adviser really come in handy. They will help you establish a retirement goal and a practical path to reaching it.
Try to Increase 401(k) Contributions Over Time
Stashing away 10 percent of your annual income may not be practical for young people new to their careers and perhaps dealing with student loan debt. And other costs can take priority, such as paying off high-interest credit card debt, putting together money for a down payment on a home, and the all-important task of establishing emergency funds that can cover unexpected expenses or sustain you for six months to a year if necessary.
Obviously, the younger you are when you start saving, and the more you can save starting early on, the better. But do what you can, and plan to increase your 401(k) contributions over time. Even if you’re hitting the 10 or 15 percent goal, you should still plan to save more in the future if possible.
Try not to Reduce Your Contributions or Make Early Withdrawals
Bear in mind that reducing your 401(k) contributions shouldn’t be taken lightly. It is very important to have some liquidity for emergencies and unexpected expenses. If you do not have a rainy day/emergency fund, then make that your primary focus, but, once you’ve started making contributions, lowering them can affect your taxes as well as your nest egg. Contributing before-tax dollars to a 401(k) plan lowers an individual’s effective tax rate. By contributing less, you may potentially have more of your salary allocated to taxes than compounding tax-free in a retirement account.
Early withdrawals from a 401k account can be expensive because of the penalties they carry under many circumstances. The IRS allows penalty-free withdrawals from retirement accounts after age 59 1/2 and requires withdrawals after age 70 1/2 (these are called Required Minimum Distributions [RMDs]). There are some exceptions to these rules for 401(k)s and other ‘Qualified Plans.’ Generally though, if you take a distribution from a 401k before age 59 ½, you will likely owe both federal income tax (taxed at your marginal tax rate) and a 10% penalty on the amount that you withdraw, in addition to any relevant state income tax.
Contact us if need advice.