If there’s one question about retirement planning that many people feel unsure about, it’s this: How much should I contribute to my 401(k) each year?
Seriously … what’s the magic answer? Is it 5%? 10%? 15%?
Take a stroll around the Internet, and you’re bound to find a number of opinions from reputable sites. For example, Investopedia is quoted as saying that “a good sweet spot is between 10% to 15%”.
That’s not surprising; especially when you consider that when you’re young (in your 20’s and 30’s) and just starting out, retirement can feel like such a long ways away.
You know you should be saving up for the future. But at the same time you’ve got to balance your finances against goals that are in the present such as your family needs, housing, vehicles, etc. And so 10% to 15% seems like a good compromise. (… The only problem is that we tend to contribute much less than that; 6.2% according to Vanguard.)
While all of this may be fine and good, I believe that if more people were to look at contributing to their 401(k) accounts the way that I’m about to show you, then they would be saving a WHOLE LOT MORE!
As you’ll see, it’s a grand opportunity to take advantage of some major, major savings.
This is why when people ask how much they should be contributing to their 401(k)’s, my answer is simple: Contribute the max!
Why You Should Contribute as Much as Possible and Max Out Your 401(k)
Let me ask you a question: Do you like to buy stuff when it’s:
- Full price or
- On sale?
I think most of us would agree that “On Sale” is the way to go! And if you’re anything like me, then you LOVE getting a good deal on something you were planning to buy anyways.
Well, believe it or not, this simple analogy applies to your retirement savings too. You have the option to either:
- Save a portion of your paycheck in a regular bank account.
- Save a MUCH LARGER portion of your paycheck without any extra effort using your 401(k)!
How is that possible?
Simple … by legally avoiding paying TAXES!
But what’s even more interesting is that this savings can be scaled!The more money you decide to put in your 401(k), the more money that you end up saving!Therefore, it would make sense to bump your contribution rate up as high as possible!
Let’s break this down using a single dollar as an example …
Saving 28% More of Your Money
For every dollar you earn, you know that you must pay taxes on it.
Using the Federal average tax rate of 22%, this means that:
- For every $1.00 earned,
- Roughly $0.22 goes to taxes and
- Roughly $0.78 is leftover for you to save, spend, … do with as you please.
This means that if you simply put your money in a bank account after taxes are paid, for every $1 you had hoped to save, you’re really only saving $0.78 of it.
That’s NOT a very good deal.
Now let’s look at how this works when we use a 401(k) instead:
- For every $1.00 earned,
- $0 goes to taxes. Remember that with a 401(k), you get to defer your taxes for decades later into the future until you are finally withdraw the money.
- Therefore, the whole $1.00 gets saved!
This is the fundamental benefit of using a 401(k) to save for retirement. You get to keep both the $0.78 you would have saved PLUS the $0.22 you would have paid towards taxes!
Which would you rather have available to save: $0.78 or $1.00?
Clearly being able to save the $1.00 using a 401(k) is the better choice! That’s roughly ($1 – $0.78) / $0.78 = 28% more for doing nothing more than being smart about how you save your money!
So, now that you understand how tax-advantaged savings with a 401(k) works, how can you use this information to get the MAXIMUM amount of benefit?
As I said before: MAX out your savings; all the way up to the IRS contribution limit!
Let me show you why.
How Saving the IRS Max = +$4,000 Saved!
As of 2019,the IRS will allow each U.S. worker to contribute as much as $19,000 to their 401(k) planevery year.
Let’s reach for the stars for a minute and consider what the benefit would be if you contributed enough money to your 401(k) to hit this upper limit.
Using the same numbers as our previous example, we now have:
- $19,000 is earned,
- $19,000 x 22% = $4,180 goes to taxes and
- $14,820 is leftover for you to save.
But again, by saving our money using our 401(k):
- $19,000 is earned.
- $0 goes to taxes. (Taxes are deferred.)
- Therefore, the whole $19,000 gets saved!
Again, by using your 401(k), you get to keep both the $14,820 you would have saved PLUS the $4,180 you would have paid towards taxes!
How many other strategies do you know of where the benefit is getting to save an extra +$4,000? To me, this is an incredible incentive to reach that IRS upper limit each and every year.
Bonus tip: Keep in mind that this strategy works per person. If you’re a couple and you both contribute to your own 401(k) plans, you have the opportunity to actually DOUBLE this benefit by saving $4,180 x 2 = $8,360 per year!
Tax-Deferred Growth for Years to Come
If that’s not already awesome enough, now consider this: All that extra savings will now grow and compound each year tax-deferred!
Remember that your 401(k) isn’t just a savings account. It’s an investment account. This means that every dollar extra you contribute has the capacity to grow and multiply for years and years to come.
This additional savings of +$4,000 is no small addition. If we look at just the difference this amount makes by NOT going to taxes, we can calculate that $4,180, over the next 30 years at a rate of 7% annually has the potential to increase to as much as $394,846.
That’s a pretty substantial increase to your nest egg!
Saving More is the Quickest Path to Financial Freedom
I usually recommend maxing out your 401(k) if for no other reason than to simply keep more money for yourself instead of paying it away in taxes.
But there is also another very IMPORANT benefit …
A high level of personal savings is the quickest and surest way to achieve financial freedom!
Believe me. I’ve read hundreds of F.I.R.E (financial independence, retire early) stories. And almost every time, behind each one, you can find that the individual or couple used a high level of savings in order to achieve their goal. In fact, here are six F.I.R.E. stories that you can check out for yourself.
I’m not talking in their 50’s and 60’s. These are people in their 40’s or even 30’s who became so financially stable that they were able to walk away from full-time employment and go do whatever makes them happy.
How is this possible?
It’s due to something I call the double-ended approach to early retirement. By saving more, you essentially teach yourself to live off of less money. This then leads to you needing less money to achieve financial freedom. And thus you reach your goal faster. You can read all about it in this post here.
So now you’ve got two VERY good reasons to strive to max out your 401(k): Keeping more of your tax money for yourself, and reaching financial freedom quicker!
Great! Now How Do I Get My Savings Rate So High?
Being able to contribute all the way up to the IRS 401(k) max is not something that most people will be able to do overnight.
Just like someone on a diet who wants to lose weight, it’s going to take a lot of discipline and will-power to get there. But given time, if you stay consistent, you will reach your goal!
It look us years to get to the point where my wife and I could each hit the IRS max limits. We started off much like everyone else contributing 10% or so to our plans. But little by little, we kept increasing our contributions until we had finally hit the ceiling.
How did we do it?
My favorite strategy is a little something I call the 401(k) raise ratchet method.
What’s that? It’s a simple little trick where you raise your contribution level every time you get a new raise at work.By doing this, you never end up missing the money because you never know any different from the previous year.
Here’s a more detailed article I wrote about how the 401(k) raise ratchet method works and why it’s so effective. I can definitely vouch for it – it was the strategy I used to slowly bump up our savings rate all the way up to the max!
Other good tips you’ll find helpful:
- The 10 Best Practical Ways to Budget Your Money and Save More
- Monthly Budget Not Working? Why An Annual Budget Is Better
At a Minimum, Get the Full Employer 401(k) Match
Okay, okay. I perfectly understand that saving all the way up to the 401(k) maximum limit will not fit into everyone’s financial situation.
My goal here was to illustrate just how great this strategy can be if you scaled it for maximum benefit.
At the absolute minimum, there is one threshold you should under no circ*mstances go below: Contributing as much as needed to get the full 401(k) employer match.
For me, this is the one number that is non-negotiable.
Why? Because anything less than this and you are simply passing up FREE money.
Most U.S. employers will now pay an incentive to their employees in the form of a 401(k) match. Sometimes this might be 50 cents to a dollar. Or sometimes its as much as dollar for dollar. On average, this works out to a match of roughly 2.7% of the employees pay.
Keep in mind that just like your 401(k) contributions, this money is tax-deferred too – meaning you pay no taxes on it right now. PLUS: It grows tax-deferred too!
So if you contribute anything less than this amount to your 401(k), you’re simply leaving money on the table. A LOT of money over time!
Don’t believe me? Just check out how much more that can build up your 401(k) over time at this post here.
To know for sure what this minimum amount should be, go to your 401(k) provider or HR representative and get the details. Every employer’s rules will be different.
What If I Don’t Like My 401(k) Plan or Can’t Contribute to One?
Unfortunately, not all 401(k) plans are the same.
Some offer really good terms while others …. not so much. It all depends on how your employer has setup the plan.
Consider:
- Some have lousy or expensive investment options
- Some plans charge high administrative fees.
- Some don’t allow you to borrow or make it nearly impossible to make a withdrawal, even with a financial hardship.
- Some won’t let you file for a 72t or SEPP if you plan to retire early.
If you have encountered these problems or your employer simply doesn’t offer 401(k) plans, relax.
The IRS also gives the option to contribute to a Traditional or Roth IRA. Like a 401(k), these savings plans allow you to make tax-advantaged contributions that can grow and compound your nest egg. But the major difference is that an IRA is under your control; it is completely separate from your employer.
To find out more, check out everything you could ever want to know about Traditional vs Roth IRA’s in our extensive article here.
Also, if you’d like more details on how IRA’s differ from 401(k) plans, then pleaseread this post too.
But How Do I Know Exactly How Much I Should Be Saving?
But how does someone find out what they number is?
With all the noise that’s out there in financial media, it’s a wonder anyone knows what’s real and what’s just there as link-bait.
I’ve read everything from articles suggesting you save up multi-million dollar nest eggs to moving to third-world countries for retirement. No thanks!
Over time, as I tested my own plans, it became clear to me that a lot of what I was doing could be used by others to help them realize their paths to financial freedom too.
This is what inspired me to write my book “How Much Money Do I Really Need to Retire & Achieve Financial Independence?”.
In it, we take a very straight-forward and practical approach to answering the question: How much do I really need to save? What you’ll discover is that depending on how you want to live in your retirement, you might not need millions of dollars at all. In fact, you might be just as safe and secure with less; not to mention a whole lot happier you were able to stop working much sooner.
If you’d like to see more, please feel free to check it out on Amazon, available in digital and paperback format.
Readers – What do you say to someone who asks: How much should I contribute to my 401(k) plan? What amount or percentage do you feel is good, and what’s your strategy behind it?
Photo credits: Flickr, FreeDigitalPhotos,Flickr
