Are you wondering how to maximize your 401(k) contribution without feeling like you won’t have any money leftover to spend?
Hey, I get it! When I was just starting out as a young professional, I started off by contributing what I thought was a decent amount to my 401(k) retirement plan (10 percent or so) …
But as we started really defining how much money we’d eventually need to retire, especially as our goal timeline transitioned from our 60’s down to our 40’s, it quickly became apparent that our savings rate wasn’t enough. If we were going to retire early successfully, then we were going to need to substantially bump up our 401(k) contributions. And by A LOT!
So how do you do that? Let’s be real … you only make a fixed amount of money each year. Where is this “extra” money supposed to come from? And how can you stay disciplined enough to not use this future savings for all of the bills and expenses that you’ve got to deal with “now” in the present?
Maybe this is why it’s been stated that over half (51%) of Americans aren’t contributing anything at all to their employer sponsored retirement plan (according to Forbes).
Well, I’m here to tell you that there’s hope! There’s a very simple way to maximize your 401(k) contributions without breaking your household budget or feeling like you have to live off of a fraction of your income.
It’s called the 401(k) raise ratchet method, and I can personally tell you that it was a very painless way for me to increase my retirement savings – all the way up until I reached the IRS annual maximum contribution limit. In fact, this method was so effective, we used it not just to increase my savings rate, but also that of my wife and our two IRA’s!
Want to see how it works? Okay … but first let’s get a better understanding of why we’ll be focusing on your 401(k) plan rather than other traditional savings options.
Why Focus on Your 401(k)?
What is it that makes saving your money in a 401(k) plan different from other ways you could be saving? Why aren’t we focused on building up a traditional bank account or investment portfolio (outside of your retirement plan)?
For two BIG reasons …
1- You Effectively Save More Money By Avoiding Taxes
Unlike traditional saving and investment accounts, a traditional 401(k), 403(b), or thrift plan (depending on where you work), is tax-deferred. This means you save your money BEFORE the taxes are taken out.
Think of it this way. When the average person thinks about saving their money, it’s often with money from their paycheck – money that they’ve paid taxes on. This means that, in reality, every dollar they earned is really only worth about 78 cents because the other 22 cents went to the government in the form of taxes.
This is where saving your money in a 401(k) can be a huge advantage! When you save money tax-deferred, every dollar earned is a dollar you could be saving for yourself. Nothing is passed on to taxes! Now you’re effectively saving an extra 28% more than if you were to try to save your money after taxes.
That’s not a point to be taken lightly. Let’s say you use this raise ratchet method and you’re able to save all the way up to the IRS maximum limit of $19,000. Do this and now you’re stashing away an extra +$5,000 more that would have otherwise went to the government. That’s a lot of extra money just for simply being smart about how and where you choose to grow your nest egg!
(To learn more about why this works, check out this post I wrote here.)
2- Getting Free Money From Employer Matching
The other big reason to focus on maximizing your 401(k) contributions before other savings options: 401(k) employer matching contributions.
What are 401(k) matching contributions? It’s FREE money your employer gives you simply for participating in their 401(k) plan!
According to the Bureau of Labor Statistics, 51% of employers in the U.S. will match some percentage of the amount of money you contribute to your 401(k) plan. That means on average you could be earning an extra 3.5% of your salary – all for just being responsible and putting it away for retirement someday.
When I used to manage several employees, I was always amazed at how many people ignored this point (or simply didn’t care). To me, it was a very simple deal: The more money you contribute, the more FREE money they give you!
How to Increase Your 401(k) Contributions Using the Raise Ratchet Method
So what exactly is the 401(k) raise ratchet and how does it help you to contribute the maximum to your 401(k)?
Simple. When you get a raise from your employer, simply take the increase amount and divide it in half. Next, increase your 401(k) contribution by whatever this amount of money is. Then repeat every time you get another raise or pay increase.
Do this enough times year after year, and eventually you’ll find yourself contributing all the way up to the full IRS maximum amount you’re allowed to make to your 401(k).
Let’s say you currently earn $50,000 per year and contribute 10% to your 401(k) ($5,000 per year).
Your employer gives you a 4% increase for the year = $2,000.
Take half of this raise amount ($1,000) and increase your 401(k) contribution to $6,000 total.
Great! Now you will be able to enjoy both having more disposable income as well as the responsible act of saving more for retirement.
Why Does the 401(k) Raise Ratchet Method Work?
The 401(k) raise ratchet method works because it doesn’t intrude upon your current budget. Strategically, you’re making contribution increases right at the moment when you’re least likely to “feel” them – when your income goes up!
According to USA Today, one of the big excuses why more people don’t participate or contribute more money into their 401(k) plans is because they say it cuts into their other “financial priorities”. This could be anything from a legit savings goal (i.e. a new home) to completely unnecessary spending habits such as a splurge at the mall. Either way, it’s a pain that most people would much rather simply avoid!
This is why waiting until you receive a raise or pay increase is the perfect time to make the switch. The effect you’d feel would be seamless.
Think about it. You’re in a transition from a point where you were OK with money to where you have more. So do you really need the extra income? To be as comfortable as the year before, probably not. If you can keep lifestyle creep at bay (the act of simply spending more money freely because you have more), then you’re likely to get along just fine on approximately whatever you spent last year.
But you might say: I earned that raise! Why should I not get to enjoy it?
And this is why I’d say start with only deferring “half”. By only diverting half of your raise towards increasing your 401(k) contribution, you get the best of both worlds – a seamless bump in your retirement savings as well as a few extra dollars to spend every paycheck.
Who says you can’t have your cake and eat it too!
How to Reach the 401(k) Max Even Faster
How badly do you want to reach financial freedom? Do you not want to wait several years until you’re contributing the IRS 401(k) maximum?
If so, then make this simple adjustment: To really accelerate your savings, increase your 401(k) contribution by 100% of raise instead of just half.
Again, the same logic applies (just on a slightly more restrictive scale). You were probably living just fine on whatever income level you earned last year, and will be able to continue to do so going forward. Though it would be fun to enjoy a little extra money, there’s no reason you absolutely have to. And since it’s going into your retirement nest egg, you know you’re doing something sensible with it.
Diverting 100% of our raises was actually the strategy we used for years to ratchet up our retirement contributions all the way up to the max. By not allowing lifestyle inflation to creep in (i.e. spending more because you have more money) and staying disciplined to our budget, most years we barely even noticed that we were diverting our raise towards this goal. And then before you knew it, we found ourselves all the way up to the maximum IRS limit.
What About My IRA?
Does your 401(k) have fees or poor investment choices? (You can use a free service such as this 401(k) fee analyzer to see how your plan compares.)
If so, then you don’t have to let that derail your savings efforts. Instead of putting your additional earnings towards your 401(k), simply put them into an IRA instead.
IRA’s are more or less similar to 401(k) plans in how they are used to help build your retirement nest egg and avoid taxes. The major difference is that an IRA is a plan setup by yourself rather than through your employer (see all the differences between an IRA vs 401(k) plan here).
Realistically, if you don’t feel comfortable with your 401(k) plan, then you can use the same strategy above to contribute more money to your IRA instead. (For a road-map of what questions to consider, please check out this post first.)
If you’d like to be really aggressive with your savings rate, you can use the raise ratchet method to keep making contribution increases until you reach the IRS threshold for both.
Again … Get Free Money From Your Employer!
I know we already talked about employer 401(k) matching contributions already. But it’s a point I feel so strongly about, that I’m going to say it again …
No matter what your contribution level is today or where you want it to be in the future, be sure to contribute enough to get your full 401(k) employer match! If you don’t, you’re simply passing up the chance to get free money with every paycheck.
The best way to approach this is to check with your HR department and get the facts. Find out (preferably in writing) how much your employer matches and what you have to do to get every last cent.
Seriously, don’t wait to use the raise ratchet. If you’re missing out on free money, act now! Take a hard look at your spending habits and adjust your budget as needed.
Don’t Try to Time the Market
Perhaps you’re fine to increase your contributions, but some recent dips in the stock market have got you scared that any money you’re putting into your retirement account is more or less being thrown away. Should you instead try to wait out the market turbulence before you increase your 401(k) contributions?
No! Unfortunately no one ever knows if the market is going to go up or down the next day, next month, or even a year from now. For this reason, we can’t “time the market”, and therefore the best policy is just to simply raise your contributions whenever you’re ready to do so.
Legendary billionaire J.P. Morgan was once asked “what will the market do tomorrow?” His classically famous answer: It will fluctuate. In other words, no one can predict whether we are at a peak or at the bottom, not even billionaire investors. So how could you ever expect to?
This was one my personal biggest mistakes back during the Great Recession starting in 2008. I received a nice company bonus but didn’t want to put any of it into investments after watching the market fall by nearly half.
In hindsight, this actually would have been the greatest time in my investment history because stocks were so cheap! A year later after stocks started to creep back up, I could have had double digit returns!
Oh well, you live and you learn.
But Don’t I Have to Wait Until Age 59-1/2 to Get My 401(k) Savings?
Yes … and no.
The IRS does state that you have to wait until age 59-1/2 to be able to gain access to your 401(k) retirement savings without penalty.
But early retirement seekers have found numerous ways around this rule. There are thousands of stories online of people in their 40’s and 50’s happily living off of their retirement savings. It’s a topic I wanted to explore myself, and I even ended up writing a whole book about it.
Saving Beyond the IRS Maximum Limit
Have you increased your 401(k) contributions all the way up to the IRS maximum and would like to keep going?
It’s not very well known, but the IRS does allow you to make after-tax contributions to your 401(k) plan (up to a certain limit). Unfortunately you would have to pay taxes on these contributions up front. But the good news is that they would grow earnings inside your retirement plan that are tax-deferred. The only catch is that your employer’s 401(k) plan has to allow for you to do this.
For more on that, please check out this post here.
Readers – How do you maximize your 401(k) contributions? What strategies do you use to bump up your savings and not make it feel like you’re breaking the bank?
Photo credits: Pexels, Unsplash