The Money Muse

When it comes to retirement savings, one of the most common questions people ask is, “How much should I contribute to my 401(k)?” Whether you’re just starting your career or getting closer to retirement, the amount you contribute can significantly impact your financial security in retirement. So, how do you figure out the right amount to contribute? Let’s dive in.

The basics of a 401(k).

First, let’s quickly review what a 401(k) is. A 401(k) is a retirement savings plan offered by many employers, allowing you to contribute a portion of your paycheck toward your retirement. These contributions are made before taxes are deducted (which means you’re saving on taxes today) and grow tax-deferred, meaning you won’t pay taxes on them until you withdraw them in retirement. Many employers also offer matching contributions, which is essentially free money – more on that in a moment.

The 15% rule.

One widely recommended guideline for retirement savings is the “15% rule,” which suggests you should aim to contribute 15% of your gross income (before taxes) to your 401(k) every year. This amount includes both your contributions and any employer match. If you can reach 15%, you’re on track to build a substantial retirement nest egg over time.

Let’s break this down:

• If you earn $50,000 per year, 15% would be $7,500.
• If your employer matches 100% of the first 3% you contribute, they’ll add $1,500 to your $7,500, bringing your total contribution to $9,000 for the year.

If you’re aiming for 15% but want to maximize your tax benefits, consider contributing to both a 401(k) and a Roth IRA. The 401(k) allows you to contribute pre-tax dollars, reducing your taxable income for the year, while a Roth IRA lets you contribute after-tax dollars with the benefit of tax-free withdrawals in retirement. By combining the two, you get the advantage of immediate tax savings from your 401(k) while securing tax-free growth and withdrawals with the Roth IRA. This strategy is a powerful way to optimize both your retirement savings and tax situation.

Take advantage of employer match.

One of the best things about contributing to your 401(k) is the potential for your employer to match a portion of your contributions. Employer matching is essentially free money that helps you grow your retirement savings faster. Many employers offer to match up to 3% or 6% of your salary, but the exact amount varies by company. Always contribute enough to take full advantage of your employer’s match – it’s essentially like a raise that you don’t have to do anything for except contribute.

For example:

• If your employer offers a 100% match on the first 3% of your salary and you earn $50,000, your employer would contribute $1,500 to your 401(k) if you contribute at least $1,500 yourself. That’s free money!
• If you don’t contribute enough to get the full match, you’re leaving money on the table.

Consider your age and retirement goals.

The amount you should contribute to your 401(k) depends on your age and your retirement goals. If you’re younger and just starting to contribute, you may be able to contribute a little less in the early years since you have more time for your investments to grow. The power of compound interest means that the earlier you start, the more your money will grow.

However, if you’re closer to retirement, you may need to contribute more to catch up and make sure you’re on track to meet your retirement goals. The IRS allows catch-up contributions for individuals over 50. In 2024, if you’re 50 or older, you can contribute an additional $7,500 to your 401(k) above the regular contribution limits, which is a great way to boost your savings as retirement approaches.

The IRS contribution limits.

The IRS sets annual contribution limits for 401(k) plans, so it’s important to know how much you can contribute. For 2024:

• The maximum contribution limit for individuals under 50 is $23,000.
• Individuals 50 and older can contribute up to $30,500, thanks to catch-up contributions.

These limits may seem high, but remember, the more you can contribute, the more you’ll have saved for retirement. If you can afford to maximize your contributions, it’s a great strategy to ensure a comfortable retirement.

Other considerations: Roth 401(k) vs. traditional 401(k)

Another important decision when contributing to your 401(k) is whether to contribute to a traditional 401(k) or a Roth 401(k), if your employer offers both options. Here’s the difference:

• Traditional 401(k): Contributions are made with pre-tax dollars, meaning you reduce your taxable income now, but you’ll pay taxes when you withdraw the money in retirement.
• Roth 401(k): Contributions are made with after-tax dollars, meaning you don’t get a tax break now, but your withdrawals in retirement will be tax-free.

Choosing between the two depends on your current tax rate and your expectations for taxes in retirement. If you think your taxes will be higher in retirement, a Roth 401(k) may be the better option. On the other hand, if you expect to be in a lower tax bracket when you retire, a traditional 401(k) may be more beneficial.

How to get started:

1. Start with the employer match: If your employer offers a match, aim to contribute at least enough to get the full match. This is free money and is the easiest way to boost your retirement savings.
2. Gradually increase contributions in your 401(k) and Roth IRA: If you can’t contribute 15% right away, start with what you can afford and gradually increase your contributions over time as your income rises. Once you reach your employer match in your 401(k), it could be beneficial to begin contributing to a Roth IRA until you reach 15%.
3. Revisit your contributions regularly: Review your contributions at least once a year, especially after any pay raises or changes in your financial situation.

Final thoughts.

The amount you should contribute to your 401(k) depends on your income, age, retirement goals, and your employer’s matching contributions. As a general rule, aim to contribute at least enough to take full advantage of your employer’s match, and work your way up to 15% across retirement accounts if possible. The earlier you start, the more time your money has to grow through the power of compound interest. Make sure to revisit your contributions regularly and adjust them as needed to stay on track for a financially secure retirement.

By prioritizing your 401(k) contributions and making consistent, smart decisions, you can set yourself up for a comfortable retirement, free from financial worries.