A 401(k) pension plan is made available through your employer. As an employee, you can contribute a certain amount of money every year, and that money is tax-free until you withdraw it after retirement.
Investing a portion of your earnings into a 401(k) should be at the top of your list of financial priorities, especially if your company will match your contributions. The earlier you start, the better your chances of saving up a nest egg for a comfortable retirement.
But how much should you contribute to your 401(k) per paycheck? The answer can significantly impact your monthly budget.
Keep reading to learn what you should look out for.
The maximum contribution available to a 401(k) plan
The Internal Revenue Service (IRS) adjusts its 401(k) contribution limits every year.
In 2021, the most you could contribute to a 401(k) was $19,500 (or $26,000 if you were over the age of 50). But in 2022, the annual contribution limit will increase to $20,500 ($27,000 for those 50 and up). If you don't max out your annual contribution, you're allowed catch-up contributions the following year.
Those limits only apply to your personal contributions. Combined personal and employer contributions were capped at $58,000 in 2021 and $61,000 in 2022.
If you can save enough money every year to make the maximum allowed contributions, you should.
If not, you’ll need to calculate what percentage of your earnings to contribute to a 401(k).
Calculating monthly contributions
Anticipate needing about 80% of your annual income per year when you reach retirement age. For example, if you earned $50,000 per year before retiring, you should aim for an annual retirement income of around $40,000.
This amount combines all of your income sources, including 401(k)s, IRAs, Social Security, and pensions.
If you want to tailor your 401(k) contribution amounts to your specific needs, consider your current age and account balance, anticipated contributions, other sources of income, and expected rates of return. You should also make a budget of your anticipated post-retirement expenses.
An easy rule of thumb is to invest 10–15%of each paycheck into your 401(k). So long as you can still comfortably afford your monthly living expenses, this amount should set you on your way to reaching your 80% income goal.
To help determine how much you should contribute to your 401(k), try an online 401(k) contribution plan calculator.
Making the most out of a 401(k)
Follow these three rules to make the most out of your 401(k):
Take advantage of compound returns
When you earn interest on your savings, it’s usually added back into those same savings, increasing the amount of interest you earn the following month, and so on for the duration of your investment. This process is called compound interest.
Compound interest leads to accelerated investment returns over time, meaning the earlier you start saving for retirement, the less you’ll need to save each month to reach the same goal.
Take advantage of matching contributions
Some employers offer to match a certain percentage of employee contributions, often about half of what you contribute up to a maximum of 6% of your salary.
Think of matching contributions as a bonus to your salary. If your company offers a 401(k) matching contribution, you should deposit at least enough to get the maximum amount. If you don’t, it’s like giving up free money.
Increase your contributions
At the absolute minimum, you should be investing enough savings into your 401(k) to get the maximum matching contribution from your employer. The recommended amount is at least 10 or 15% of your income. If possible, you should invest more than that.
If you can’t afford that much yet, that’s okay. But you should plan to increase your contributions whenever you pay off a debt, eliminate another expense, or receive a raise.
Discovering the right ratio for savings
Some people find it helpful to determine a set ratio for how much they allot to expenses, savings, and charitable donations every month.
A simple ratio might be to spend 50% of your income and save the other 50%. But you might not find those numbers realistic, especially if you need to spend 90% of your income on basic living expenses. The best ratio for you depends on your financial situation.
If you can afford it, a good starting point is to spend 75%, save 20%, and give 5%.
For example, if you earn $50,000 annually, you could allot $37,500 — or $3,125 a month — to your expenses, and you could save $10,000 a year — or $833 a month. Then you could set aside $2,500 a year for donations to your choice of charities or non-profit organizations.
Two basic rules for saving
These two rules will help you simplify your retirement savings:
If your employer matches 401(k) contributions, put in enough to get the full match. You should do this before paying off your debt because even if your employer only matches half of your contribution, it’s an instant 50% return on investment. That's considerably more than you pay in interest on a credit card.
Next, if you can afford to contribute more to your savings, begin by contributing the maximum allowance of $5,500 a year to a Roth IRA. Then, if you still have money left for savings, you can make extra contributions to your 401(k).
Tax impact on 401(k), Roth, and IRA
Your investments in a 401(k) are tax-deferred. Your contributions come out of your paycheck pre-tax, and you’re only taxed on that income when you withdraw it after retirement. That means you end up paying income taxes on the interest you earned on those savings. The same applies to traditional IRAs.
On the other hand, with a Roth IRA or Roth 401(k), your contributions are taxed upon deposit and distributions in retirement are tax-free, meaning you don’t pay taxes on the interest you earn on your investment.
Retiring with $1 million
Let’s say you want to retire with $1 million. That might seem like a lot, but look at it this way — if you want your savings to last you 25 years, $1 million amounts to $40,000 per year (or 80% of a $50,000 annual salary.)
If you retire at 55, which is the earliest you can start withdrawing from your 401(k), saving $1 million and spending $40,000 a year will last until you’re 80. If you retire at 65, it will last until you’re 90.
Let’s look at how much you would have to put in your retirement account every month to reach that goal. The most important factors to consider are your age and the average rate of return on your investment. Assuming an annual salary of $50,000, below are some hypothetical contribution calculations.
If you start at age 25:
- With a 6% rate of return on your investments, you’ll need to contribute $499.64 per month (or roughly 12% of a $50,000 annual salary).
- With an 8% rate of return, you’ll need to contribute $284.55 per month (or about 7% of your salary).
If you start at age 30:
- With a 6% rate of return, you’ll need to contribute $698.41 per month (or about 17% of your salary).
- With an 8% rate of return, you’ll need to contribute $433.06 per month (or about 10% of your salary).
If you start at age 40:
- With a 6% rate of return, you’ll need to contribute $1,435.83 per month (about 34% of your salary).
- With an 8% rate of return, you’ll need to contribute $1,044.53 per month (about 25% of your salary).
As you can see, the earlier you start making contributions to a retirement savings plan, the less you’ll have to invest every month and the less it will cost you overall (thanks to compound interest).
The bottom line
Saving up for retirement should be an essential part of your financial planning, and the decisions you make now will have a significant impact on your finances later in life.
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