How Much of My Salary Should I Contribute to My 401(k)?
There is no definite answer to how much you should contribute to your 401(k) since everyone’s situation is different. Salary, bills, goals, etc. all differ for everyone, so it’s tough to determine a set amount that everyone should follow. But there is a commonly accepted range of percentages that you should aim for to contribute to your 401(k).
10 - 20% of your income.
Right in the middle of that range, 15%, is typically what many financial advisors will recommend that you aim for. With 15% going into your 401(k), you should still have plenty of money left over to pay all of your bills and still enjoy your life. It’s a great balance between enjoying life now and setting aside money to enjoy life later as well.
You don’t want to get caught up in only living for the moment and not contributing anything towards your retirement. Suddenly you’ll reach retirement age and realize you have nothing saved up. On the flip side, try not to get caught up in only savings for retirement. You want to enjoy your life now as well! So setting aside 10-20% of your income will allow you to do both.
What’s the Most I Can Contribute to my 401(k)?
Don’t forget about those pesky contribution limits from the IRS! As of 2021, you can contribute a maximum of $19,500 per year. This increases to $26,000 if you’re over the age of 50. The total that can be contributed between yourself and any employer match — more on the match shortly — is $58,000 per year.
So if you’re a high-income earner, you may not be able to contribute 10-20% of your income to just the 401(k). You might need to open up an IRA alongside to ensure you’re setting aside enough for a comfortable retirement!
How Does a 401(k) Match Affect My Contribution?
A 401(k) match is a portion of your salary that your employer is willing to add to your 401(k) account as they match some of your contributions. Typical employee matches are around 3-8% of your salary, and they require you to contribute a certain amount to your 401(k) to be eligible for the match. It’s important to understand how your employer’s match works because you always want to try to contribute at least enough to get the full match since it’s basically free money.
Employers will typically offer either a partial match or a dollar-for-dollar match. Without getting into too many details about all the different ways that an employer offers a 401(k) match, let’s take a look at a simple example. This will help you see how much you should contribute to your 401(k) at a minimum so that you can take full advantage of this extra money.
If your employer offers a dollar-for-dollar 401(k) match equal to 8% of your total salary, then you should contribute at least 8% of your pay to your 401(k). If you’re making $50,000 per year, this means you’ll be contributing $4,000 annually. On top of that, your employer will be adding an additional 8% of your salary ($4,000 more) to your 401(k).
Anything over 8% that you contribute will not be matched, but you can still add as much as you like (up to the max). However, if you don’t contribute 8%, then you won’t get the full 401(k) match. Say you decide to only contribute 5% of your salary ($2,500). This means your employer will also only contribute 5% to your account. So you would miss out on $1,500 in free money, and your account would only grow by $5,000 total instead of $8,000. This will really add up over time!
What Are the Tax Implications of a 401(k) Contribution?
As one of the main reasons to contribute to a 401(k) — outside of the employer match — it’s important to understand the tax implications involved. 401(k) accounts are tax-advantaged and tax-sheltered.
Being tax-sheltered means that you are not responsible for paying taxes on anything that goes on within the 401(k) while it is active. So any buying and selling of funds throughout the life of the 401(k) is not immediately taxed as it would be in a regular account. But whether or not that money is ever taxed depends on what type of 401(k) account it is.
The most common type of 401(k) that you’ll come across is the traditional 401(k). In a traditional 401(k), you contribute to the account with pre-tax dollars. This means that any amount of money you contribute to your 401(k) lowers your taxable income and saves you money on those taxes now. However, when you go to start withdrawing the funds from your 401(k) later in life, you’ll have to pay taxes on the full amount — both your contributions and any earnings.
The other type of 401(k) that you might see is the Roth 401(k) option. In a Roth 401(k), you contribute to the account with after-tax money. This means you’ve already paid taxes, and the contributions are just removed from your take-home pay before it goes into your bank account. So you’re paying taxes not, but in the future, all of your 401(k) withdrawals will be tax-free. This could potentially make your retirement years much easier since you won’t owe taxes.
How Does a Roth 401(k) Affect my Contribution Percentage?
When you’re deciding what percentage of your income to contribute, you might want to take the type of 401(k) that you’re using into account. Let’s look at a quick example, where you’re making $100,000 per year and you want to contribute 15% of your income. This would be $15,000 per year.
In a traditional 401(k), $15,000 of your income would come out pre-tax and just go straight into your 401(k) account. This would mean you’re paying taxes on $85,000 this year. In a Roth 401(k), that $15,000 would have to come out of your after-tax money. Let’s say you’re paying 20% total in taxes, this means you’d technically be contributing $18,750. That’s because you’d first owe 20% in taxes before you can contribute that $15,000.
So as you can see, contributing the same percentage to a Roth 401(k) means that you effectively have to contribute more because of the taxes. But in the future, you won’t owe anything on any of your Roth withdrawals, which is going to be a huge savings. Just keep in that mind as you’re going over your finances, and consider adjusting the percentage slightly depending on the account type.
Should I Contribute to an IRA Instead of a 401(k)?
In general, 401(k)’s and IRAs act in very similar ways. With IRAs, you have the same two main options — traditional and Roth — that you have in 401(k) accounts, and they undergo the same tax advantages. So some people wonder whether they should bother opening an IRA in addition to their 401(k) or just contribute their full percentage to the 401(k).
One of the main reasons why people decide to open an IRA is for more control over their investments. With a 401(k), you typically have limited fund options that you can invest in based on what your employer is providing. In an IRA, you’re able to invest in anything that you want. So if you want to invest in specific companies or funds for retirement, the IRA may be worth looking into.
Secondly, you might want to open a Roth IRA and contribute to that alongside your traditional 401(k). This is a great way to take advantage of both sides of the tax advantages while you’re saving up for retirement. Whatever you do with an IRA, be sure you’re still contributing enough to your 401(k) to get the full match. Any amount left that you’re willing to contribute, putting it in a Roth IRA is not a bad idea!
How Much Do I Need for Retirement?
There is no definite answer to this question that will work for everyone. Some people want to make enough to just pay their bills and live a quiet life. Others want to have hundreds of thousands of dollars in annual income during retirement so they can live out their golden years in style. It really comes down to how much you want in retirement, and then you can work backward to figure out how much you need to set aside.
One of the most famous financial studies of all time, the Trinity Study, set out to find a safe withdrawal rate in retirement. They wanted to see how much you could withdraw from retirement accounts and have a very high chance of never running out of money. Based on their findings, the “4% rule” was formed, which is a great rule of thumb to start planning out how much you need for retirement.
Under the 4% rule, you basically just need to determine how much annual income you want to have during retirement and multiply that by 25. So for example, if you want to withdraw $50,000 annually, you’d need to have $1.25 million in your accounts invested in typical investment options. That would enable you to withdraw 4% annually and have a great chance at never running out of money.
So start thinking about how much you’ll want to have for retirement and you can get an idea of where your accounts need to be. Even if you don’t know how much you’ll want, just start setting aside around 15% of your income. By the time you reach retirement age, you’ll be in great shape to live how you want!