Are stuck trying to determine how much money you should be contributing to your 401k? It’s a tough decision to make because even though you know that more is better, you also probably need your money now. So how much do set aside without cutting your paycheck down to the bone?
Most financial advisors will recommend that the average person should be trying to save at least 10 percent of their income for retirement. However, that’s a pretty broad recommendation. The amount that you’ll actually need for retirement will be highly dependent on your personal situation and definitely involve some further questions.
In this post, we’ll go through five factors you should consider and help you figure out your optimal contribution rate.
1. What is Your Retirement Goal?
The first thing to consider when you’re thinking about retirement is your overall goals. Namely: when would you like to retire and how much will you need?
The “when” is a big question because there’s a big difference between someone who wants to retire in 10 years versus someone else who can wait 20 years. The sooner you’d like to have enough money to be done working, the more aggressively you’ll have to save and invest.
The “how much” can also have just as big of an impact. Your end target will be heavily dependent on your particular living expenses and how comfortable you’d like to be. A person who can retire on $1 million versus someone who believes they will need a $2 million nest egg can contribute a lot less to their 401k if they wish.
If you’ve never attempted retirement planning before, then a tool like the Buxfer Retirement Planner can be helpful. This is a feature of the app that allows you to input your retirement variables and see how it affects things like your timeline or forecasted nest egg balance. This can be an eye-opening exercise in learning just how much money you truly need to save in order to reach your goals.
2. What’s Your Investment Style?
One of the things a lot of people don’t realize is that the way they invest could have a significant bearing on their savings rate.
Take this simple example: Let’s say you wanted to grow your nest egg to $1 million over the next 30 years. But instead of investing in stocks, you choose to invest in conservative funds that only produced 1% above inflation. In that case, you’d have to save $2,396 every month – more than what you’re even allowed to put inside a 401k!
On the flip side, you also don’t want to invest in stocks or funds that are too risky because you can lose your entire life savings very quickly. A better approach is to stick with a standard large-cap stock index fund that follows the S&P 500. Funds like this tend to produce an average annualized 7% real return over the long term. With investment growth like that, you’d only need to save $882 per month in your 401k which is a far more reasonable target.
3. How Sure Do You Want to Be That You Won’t Run Out of Money?
When retirement planners estimate how much your nest egg should be, they base this on an old rule of thumb called the 4 Percent Rule. Under the 4 Percent Rule, you can take your living expenses and divide them by 0.04 to determine how much you’ll need. For example, if you needed $60,000 per year, then your nest egg target should be $60,000 / 0.04 = $1.5 million.
However, you should note that the 4 Percent Rule only assumes your savings will last approximately 30 years. Unfortunately, with stock prices at historically high levels and bonds at some of their lowest rates ever, many financial experts caution that the inputs used to justify the 4 Percent Rule may be outdated.
If you’d prefer to play it safe, you’re always welcome to use a lower withdrawal rate such as 3.5 or even 3.0 percent. However, the added security comes at the cost of needing to save up even more. For example, a 3% withdrawal rate would mean shooting for a nest egg with $60,000 / 0.03 = $2 million. That’s going to mean contributing even more to your 401k.
4. Does Your Employer Offer Matching?
Does the place you work offer 401k employer matching? 401k employer matching is when the company will match your contributions, usually dollar for dollar or 50 cents to a dollar up to some limit.
Despite being offered essentially “free money”, approximately one-third of employees don’t contribute enough to their 401k to get the full company match according to Vanguard. This is unfortunate because it could be the easiest way to add a couple extra thousand dollars to your nest egg every year.
If your employer offers company matching, then need to contribute at least the minimum amount needed to get the full benefit. If you’re unsure about what that number is, contact your local HR department and find out what the rules are (preferably in writing).
5. How Much Less Tax Would You Like to Pay?
Finally, the last point to consider when setting your 401k contributions is how much you’d like to pay in taxes. Let me explain what I mean.
Recall that every dollar you earn requires you to pay federal income taxes. Most middle-class filers will fall into the 22% or 24% tax brackets. However, because of the way a 401k works, every dollar you save is a dollar that you don’t have to pay taxes on this year. In other words, the more you save in your 401k, the lower your tax bill is for the year.
Here’s a simple example: If you contribute $10,000 to your 401k this year and are in the 22% tax bracket, then you’ve effectively reduced your tax bill by $2,200. Instead, those taxes will be deferred into the future someday when you retire.
Starting in 2022, the maximum amount you can save in your 401k is $20,500. If you’re age 50 and older, then you’re allowed to make additional “catch-up contributions” of $6,500 bringing this number up to $27,000.
It may not be the most important reason to contribute more to your 401k. But it is certainly helpful to realize how much more you’re actually saving.
Image credit: Pexels
Buxfer Blog 