It’s one of the most commonly asked questions of employees when they start saving for retirement: How much should I put in my 401k? 5%? 10%? 15%?
Especially 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 that you should be contributing, but at the same time you want to enjoy your earnings and save towards other goals like a house and family needs too.
To simply answer this question with “save as much as you can afford” feels too much like an easy-out. I’ve recommended that advice to friends in the past only to find out that they end up saving only a measly 2 or 4% of their paychecks. Since I’m friends with them, I KNOW they can do much better than that.
So now I’ve changed my mind and came up with a much simpler answer to this question. But it will probably not be one that you’re going to like:
I tell them to contribute as much as you’re allowed!
Why You Should Put As Much As Possible In Your 401k:
Now before anyone starts throwing stones or firing off rants about how they only make “whatever” amount of money and that this isn’t rational advice, please hear me out first.
The reason I say to try to contribute as much to your 401k as you’re allowed is because by doing so you’re taking the opportunity to avoid paying taxes on your money.
Plain and simple – that just means more money for you!
Save 33% More:
Think about it this way: If your tax rate is 25%, then you lose 25 cents for every dollar you earn.
So when you get a paycheck for $1,000, you really only get to keep $750 while the other $250 goes to taxes. If you had hopes to save 10% of your income ($100), then you’re really only going to get to save $100 x 25% = $75 by time taxes are taken out.
But that’s not the case with a tax-sheltered account like a 401k. With a 401k you get to save your money before you pay taxes on it. So by getting that extra $25, you actually get to keep $25/$75 = 33% more than if you had tried to save that money outside the tax-sheltered account. In other words, at a 25% tax rate, you get to keep 33% more of your money every year!
Reaching the IRS Max:
Starting in 2015, the IRS will allow savers to stash as much as $18,000 in their 401k plan every year. ($24,000 if you’re 50 or older.)
Imagine you’ve diligently worked your way up to saving the full annual 401k max limit. Since you’re being smart and realizing that you’ve got a unique chance to save a ton of money in taxes, how much money do you think you’d save yourself in JUST taxes for the year?
$18,000 x 25% = $4,500
Again, if you didn’t save your money in a tax-sheltered account, then you’d only get to keep $13,500 of that $18,000.
Over the Next 30 Years:
If that’s not good enough for you, then wait until you see what happens when you invest that money every year over the next 30 years. Eventually it grows up to be a pretty substantial sum of money. At an 8% annualized rate, $4,500 saved every year will have the potential to grow as big as $509,774!
And that’s JUST in taxes saved! (I’m not even counting your principal.)
The takeaway: For every dollar you save in your 401k, you’re essentially keeping 33% more of your money. You can either give your money to Uncle Sam or keep it and let it grow to over a half-million dollars. It’s your call.
Start Off Saving Big, Start Strong:
In case you’re not sold on the taxes aspect of this argument, I’ve got another totally valid reason why saving as much as possible is worth it.
It’s call compound interest.
Because of the way compound interest works, the more capital you build up sooner, the higher the returns you could earn. And once that starts, it takes off with a mind of its own!
Check this out: Let’s say there are two employees A and B.
- Employee A saves hard for the first 10 years and then abruptly stops saving.
- Employee B waits 10 years to start saving and then saves just as hard as Employee A for the next 30 years.
Who will end up with more money? The one who saved for 10 years in the beginning or the one who saved for 30 years at the end?
Come ‘on … its got to be the one who saved for 30 years, right?
It turns out Employee A who saved hard in the beginning ends up with more money.
Why? Because they built up their capital faster in the beginning than Employee B. So they gave the money a better chance to start producing its own returns which were larger than what Employee B was working with.
The takeaway: Use the power of compounding returns to your advantage. Start off saving big!
At a Minimum Get the Full Employer 401k Match:
Okay, okay. I perfectly understand that this whole save $18,000 may not fit you or your financial situation. My goal here is to simply trying to illustrate how much money you could be saving yourself by using the extremes. Perhaps think of it as a good stretch goal.
Putting that part of the discussion aside, there is one very SERIOUS goal that you absolutely must reach when thinking about how much to put away in your 401k:
Contributing as much as needed to get the full 401k employer match.
If you don’t, you’re just passing up FREE money; money that is rightfully entitled to you tax-free. Just check out how much more that can build up your 401k over time at my post here.
The takeaway: Even if you can’t reach the full 401k maximum contribution, at least get all you can get from your employer. That one is a no brainer.
If you’d like an easy way to keep track of your 401k account or if you’d like to play with the variables and see what kind of a difference certain savings rates will produce over time, Personal Capital is a free service you can sign-up with that will do all that. Every week they’ll email you a portfolio status that will let you know how your account is doing. Once you log-in they’ve also got a section where you can predict how much your account will grow over time at certain savings rates, etc. It’s pretty handy for a free service.
Sometimes a 401k Is Not for Everyone:
Everyone’s financial situation is always just a little bit different. And there will be times when a 401k just doesn’t work. Consider:
- Sometimes they don’t have the best or cheapest investment options.
- Some don’t allow you to borrow.
- Some 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 these are situations you think you might encounter, perhaps a Traditional or Roth IRA may be a better suited tax-sheltered investment for you. An IRA can do a better job of giving you more control and say over how the money is managed.
For my own situation with planning for early retirement I know that when I eventually leave my job I’ll want to do a 401k to IRA rollover. That will allow me to access the money early using a SEPP if needed.
Readers – How do you respond when people ask you how much should I put in my 401k? Do you have a certain number or percentage you usually recommend?
Image courtesy of Alan Cleaver | Flickr