We all like rules of thumb, don’t we? They reduce the complex to something simple. No where does this feel better than when it comes to saving for retirement. Just give me a number to shoot for and I’ll make it happen!
If only it were that simple. So how much should you contribute to your retirement account, and in particular to what is typically the largest single retirement account for most people—your 401k? The answer: it depends!
There is no one answer across the board, since everyone’s situation is different and must be based on a number of factors. Some of those factors include:
- How many years it will be until you retire
- What other retirement income sources you expect (Social Security, other investments, pensions, etc.)
- Your expected lifestyle
- Current retirement savings available
- Current income level
- Current debt and living expenses
Once you determine where you stand with these, you can begin determining how much to save in your 401k based on more objective factors.
Funding up to the employer 401k match
Probably the most popular advice on 401k contributions is that you fund up to the maximum that your employer will match. If you’re employer will match at a rate of 50% of your contributions up to six percent of income, then you should contribute at least six percent in order to get the largest possible match.
If you follow this rule, your contributions will be effectively nine percent—six percent from you, plus the three percent match from your employer.
This is solid advice in as much as it allows you to take advantage of the largest possible match from your employer, but it may not be the best rate for your circumstances. If your current level of retirement assets is not high enough to insure the type of retirement you plan to have, the employer match will be a secondary consideration since you will need to contribute an amount well beyond the match.
The most you can legally contribute under your plan
The most you can legally contribute to your 401K for 2012 is $17,000, and the IRS raises this by $5,500 if you’re 50 or older. Beyond the maximum dollar figure you’re allowed to contribute, your employer will have a uniform maximum percentage of income limit, which will vary from one employer to another.
If your employer caps employee contributions at 20% of income, and you earn $60,000 per year, your maximum contribution will be limited to $12,000, not $17,000. In this example, you will never reach the maximum amount the IRS allows unless you can increase your income substantially.
Your employer’s 401K policy will establish the most you’re able to contribute to your plan. Your choice then will be to determine how much of your income to contribute within the employer’s limits.
The minimum until you pay-off your non-housing debt
Debt has a major impact on retirement planning and sometimes needs to be prioritized ahead of 401k contributions. There are two major reasons for this:
- Debt is an immediate concern—it must be serviced now, while 401k contributions are a provision for the future
- Debt reduces the amount of income you can devote to your 401k—the sooner it’s paid off, the more money you can contribute to your retirement
Due to compounding of investment returns, it’s important to begin funding your 401k as early in life as you can, and to continue funding at the highest level you can. But if you have debt—especially a lot of it—you will also need to have a plan to pay it off. That will mean keeping 401k contributions to a minimum while concentrating as much income as you can on paying off the debt.
In this instance, you may consider funding your 401k in an amount sufficient to maximize the employer match, as outlined above. If you really want to be aggressive in getting out of debt, you’ll probably want to keep your contributions even lower. The benefit of paying off your debt will be having more money to put into your 401K later.
Contribute as much as you can
If you’re in your 40s or 50s and don’t have sufficient retirement assets, you’ll want to do what you can to contribute the most you can to your 401k. That will mean contributing up to the maximum of your company’s limits, and all the way to the IRS limits, if your company’s rules will allow it.
If for whatever reason such contributions won’t be sufficient, you may also need to look beyond your 401k for retirement provisions.
Within certain income limits, the IRS allows you to make contributions to both IRA’s and Roth IRA’s even if you have a 401k from your employer. But even if you can’t contribute to these plans, you can also save money in non-tax sheltered savings. Investment accounts, mutual funds, and certificates of deposit were how people saved money for retirement before qualified retirement plans came into existence, and they’ll work just as well today.
But before you look into any of those, contribute the most you can to your 401k—the tax savings are hard to beat!
Do you max-out your 401K contributions? If not, is there another way to save for retirement that you think is more effective? Leave a comment below!