401(k)s are one of the most common savings tools people have for their retirement. But if you’re just getting started or are dealing with debt, how much should you put in your 401(k)? Should you get the employer match? Contribute 6%? 10%? 15%? How about 20%?
What if you’re looking to retire early at age 35? Or 50? Will those goals make a difference of how much you should put in your 401(k)?
Understanding your 401(k) is a critical part of making sure you’ll have enough money during retirement. Unfortunately studies show employee education is lacking on helping people understand why to invest, what to invest in, and the power of having a long term plan. This article will help you understand and decide for yourself how much you should contribute and why.
No two situations are the same
Scenario #1: Joe is 23 years old and just started working a $40,000/year job as a teacher. He has $80,000 in student loans to pay off with high-interest rates. Joe wants to work in his field until he’s sixty.
Scenario #2: Susan and Juan are in their mid 30’s and married. They have two young kids, car loans, a mortgage, school loans, and no savings. Susan is a stay-at-home mom.
Scenario #3: Casey is 28 years old and living paycheck-to-paycheck. He’s just learned about the FIRE movement (Financially Independent, Retire Early). He wants to turn his financial situation on its head and retire at age 40, so he can travel the world.
I could go on for the next five weeks coming up with different scenarios. What’s yours?
There are some considerations as to how much you should contribute to your 401(k) depending on your stage of life:
- How much should you contribute if you’re in debt?
- How much should you contribute if there is no company match?
- How much should you contribute if you want to retire early?
- How much should you contribute if you’re in a high tax bracket?
- How much should you contribute if you’re in a low tax bracket?
- Is the 401(k) the best option for you compared to a Roth IRA?
401(k) contributions if you’re in debt
What to do if you’re in debt trips everyone up. Some personal finance experts will tell you to stop all retirement contributions and focus all your efforts on paying down debt. For example, maybe you want to pay off your student loans faster.
There is truth in that you will get out of debt faster if you divert every spare dollar you can towards your debts.
But there may be a long-term cost if you’re giving up an employer match. Here are my suggestions:
If there is no employer match: Forget about the tax deduction. Pay down your debts because they carry an interest rate that costs you money each month.
If there is an employer match: Yes, that’s free money. It’s hard to turn down a 100% return or 50% return when you might have a debt that’s costing you 12% in interest each month. Financially it doesn’t make sense to give up a 50%/100% return for a debt costing 12% in interest. It’s a personal choice you’ll have to make for yourself.
Things to consider when paying down debt and stopping all 401(k) contributions if there is an employer match:
– You’ll get out of debt faster
– You’ll pay less in interest on your debts
– You’ll be debt free faster
– You will have less money in retirement
It’s a mathematic certainty if you skip the employer match you’ll have less money in retirement. But sometimes the peace and security of being debt free is worth the cost. You also have to consider how much money you’ll need in retirement.
Should I contribute to my 401(k) if I don’t have an emergency fund?
Everyone needs to have an emergency fund to cover life’s unexpected situations:
- Job loss
- Medical emergency
- Unplanned pregnancy
- Bailing your stupid cousin out of jail and paying for their lawyer because you’re the only smart one in the family that has saved any money.
Keep it simple – if you have paid off your debts (except a mortgage), start building up a 3–6 month emergency fund. Get any company match in your employer’s retirement plan. Then divert the rest of your savings to a nice cash cushion for the bad times ahead. We all have bad times in our life, best to prepare for them.
What should you invest in if there is no employer match in your 401(k)?
If your employer doesn’t give you any incentive to contribute to a 401(k), hands down the best option is to start a Roth IRA.
Note: If you have access to a Health Savings Account and you’re in a high deductible healthcare plan, using an HSA for retirement and health insurance savings can be better than a Roth IRA.
The Roth IRA is a retirement account that grows tax-free, and you can withdraw the money tax-free during retirement. The Roth IRA differs from a 401(k) in that it doesn’t give you a tax break now on your income.
How much should you contribute to a Roth IRA?
The Roth IRA has a yearly contribution limit of $5,500. That’s your savings goal – maxing out your Roth each year at $5,500. If you have a spouse, try maxing out one for you and one for your spouse.
Best places to open a Roth IRA
Here are the best places to open a Roth IRA and get started saving for retirement:
- Vanguard – Discount broker
- Fidelity – Discount broker
- TD Ameritrade – Discount broker
- Charles Schwab – Discount broker
- Betterment – Roboadvisor
- Acorns – Roboadvisor
Note: These companies do not pay me for advertising or give me kickbacks. I have had my investments at all of the discount brokers listed at one time or another. I have a small trial account with Betterment to help me understand and follow their service. I have affiliate relationships with Betterment and Acorns where I donate all referral fees to avoid any conflict of interest.
How much should you contribute to a 401(k) based on your current income and tax bracket?
You will pay more money in taxes than anything else in your lifetime. Tax planning is critical to building long-term wealth.
When you start withdrawing money from your 401(k), the money is taxed at your ordinary income tax rate. So if you’re in the 25% tax bracket now and were to pull out some money, it would get taxed at 25%. Ok, that’s not exact because we have a progressive tax system, but let’s just keep things simple.
If you were in the 28% tax bracket now and pulled out some money, it would get taxed at 28%.
So the higher your tax bracket in retirement, the more taxes you will pay on 401(k) withdrawals.
Most financial planners agree with the following:
If you’re in a high tax bracket now, max out your 401(k) to get the tax deduction now. The hope is you will be in a lower tax bracket during retirement. You’ll pay less taxes then. However, that also assumes the tax brackets are the same when you retire, whenever that is.
If you’re in a low tax bracket now, get any company match then contribute to a Roth IRA. The tax deduction you would get now from maxing out a 401(k) and then doing a Roth isn’t worth it.
How to pay zero taxes
If you want the details on why, and want to learn how to save money on taxes listen to my eight-part tax series. I guarantee you’ll learn a ton about taxes, including how to pay zero taxes.
How much should you contribute to a 401(k) if you want to retire early?
If you withdraw money from a 401(k) before age 59 1/2, you will pay a 10% penalty on the amount, in addition to the ordinary income taxes.
So where are people getting money to live on if they retire at age 35? 40? 45? 50? 55?
There are several strategies early retirees use to meet their living expenses (eat!) while they wait to access any potential 401(k) investments at age 59 1/2.
- Put money in taxable investment accounts at a regular brokerage (see the list above)
- Generate passive income (rental property is the most common)
- Withdraw contributions from Roth accounts. Your contributions (not gains) from Roth IRAs can be withdrawn without penalty at any time before age 59 1/2.
- Work part-time to supplement investment and passive income
Online calculators can help you figure out how much you need to save to retire. And that’s key – your savings rate is more important than the rate of return. Try out this calculator to see when can I retire?
There are a lot of factors that go into figuring out the amount, and they are unique to your situation.
- Years until retirement
- Cost of living
- Types and amounts of savings
As a general rule, the earlier you want to retire the greater percentage of your income you’ll need to sock away. It’s not unusual for people who want to retire early to save 50% or more of their income.
Aren’t 401(k)s only for high-income earners?
I attribute my success to this: I never gave or took any excuse. – Florence Nightingale
The fact is many working families with average incomes have become 401(k) millionaires. It’s very simple to do:
- Set aside a percent of your income before spending your paycheck. Also known as pay yourself first.
- Invest that money in things like stock and bond funds that have a higher return than your savings account at the bank.
- Follow the four nevers:
- Never stop adding money.
- Never borrow against your retirement accounts.
- Never sell your investments when the markets go down (market timing).
- Never touch the money until retirement.
Note I said simple. It isn’t easy. The reason it isn’t easy is that we live in a consumer society. We’re spenders, not savers. But by living below your means and saving first, it’s not only possible; it’s probable you’ll build wealth.
If you still don’t believe me, please read this story about how an everyday family retired with $1 million.
Recap for retirement savings
The general savings plan for most people is:
- Pay off your debts.
- Max out your 401(k) up until any employer match. It’s free money. You have to decide for your own situation if paying off debt and getting the company match is best for you.
- Get an emergency fund in place.
- Max out your HSA and use it for retirement.
- Max out a Roth IRA
- Max out your 401(k) up until the yearly allowable limit
- Dump extra money into a brokerage account
Note I said general. When you start thinking about early retirement those steps may not get you to retirement in the fastest way possible. For example, if you take the money from steps 4–7 and buy rental homes instead, you could cash flow early retirement sooner. Or not! You have to run the numbers for yourself.
Figure out how to max out your 401(k)
Try out this online 401(k) calculator to determine how much to contribute each pay period so that you can save the maximum amount in your 401(k).
The most important piece of advice I can give you is to just start. Log in to your 401(k) and contribute 1% – that’s one penny of every dollar you earn. Automating your savings is a key to building wealth. As you get raises and bonuses, try to save 50% of every raise and bonus.