your 401(k) #4: Contributions
“How much should I contribute???”
That’s one of the most commonly asked 401(k) questions. You know you should be putting money into your account, but you have no idea how much. Let’s change that right. now. It's time you have a plan for your retirement savings.
First things first - what does the word "contribution" mean? Contribution is a fancy term for the money you put into, or contribute, to your account. In a 401(k), your contributions come directly from your paycheck.
Important: There's a BIG difference between how much you can contribute and how much you should or realistically will.
Because 401(k) contributions receive certain tax benefits, the IRS caps the amount that individuals can deposit in a given year. Regardless of income, in 2016, the maximums you can contribute to retirement accounts are:
- 401(k), 403(b), or 457: $18,000
- SIMPLE plans: $12,500
- IRA: $5,500
*There are exceptions to those numbers, though! If you’re 50 years or older, you can contribute additional amounts in what are called catch-up contributions. The purpose of these catch-ups is exactly as it sounds: to give people near retirement who haven’t saved enough money a chance to "catch-up" to the where they should be financially. The catch-up and combined yearly maximums are:
- 401(k), 403(b), or 457: $6,000 for a total of $24,000 ($18,000 max + $6,000 catch-up = $24,000 total)
- SIMPLE plans: $3,000 for a total of $15,500 ($12,500 max + $3,000 catch-up = $15,500 total)
- IRA: $1,000 for a total of $6,500 ($5,500 max + $1,000 catch-up = $6,500 total)
However, if you have a 401(k) or 403(b) AND a 457, things get a little more interesting. You can actually contribute the max to BOTH - so $18k to a 401(k) and $18k to a 457 for a total of $36k.
Okay, okay. I know that saving $18,000 each year is nowhere near realistic for most people. Therefore, the more appropriate question to ask is “How much should I contribute?” Since everyone’s retirement goals are different, there’s no right answer to this question. However, there are some ways to go about estimating how large your retirement account will need to be.
To start with, ask yourself questions like these:
- “At what age do I want to stop working?”
- “What do I want my last life chapter to look like?”
- “Where do I want to live?”
- “What do I want to be doing, and with whom?”
- “Do I want to own a vacation home and travel a lot?”
- “Would I be perfectly happy living in a house that’s paid for, spending time with family, and taking up a hobby?”
Once you have an idea of what you want the last third of your life to look like, use one of these methods to figure out how much that dream life will cost:
#1 - INCOME METHOD
Experts say you’ll need to have anywhere from 15 to 20x your pre-retirement income saved. To be safe, I'd err on the high side. Here are some examples:
- If you’re making $50k per year before retirement, experts say you should have at least $750k to $1 million put away.
$50k x 15 = $750k and $50k x 20 = $1mm
- If you’re making $100k per year, you’d need $1.5 to $2 million, and so on.
$100k x 15 = $1.5mm and $100k x 20 = $2mm
#2 - EXPENSE METHOD
Estimate how much you expect your annual expenses to be in retirement, then multiply that number by 25. It may seem like overkill, but between property taxes, insurance, food, travel, etc, expenses add up quickly.
Let's assume that these are your average monthly expenses right now:
- House payment / Rent: $1200
- Utilities: $200
- Gasoline: $200
- Food: $400
- Insurance (health/car): $500
- Miscellaneous (clothes, travel, entertainment): $500
So for the full year (monthly expenses x 12), your total annual expenses are: $36k. Multiplying that number by 25 estimates your nest egg needs to be around $900k.
#3 - % OF CURRENT INCOME
Experts say you should be putting away 10-20% of your income every year.
- If you’re making $50k/year, that’d mean socking away $5k to $10k per year for retirement. 15% of $50k is $7500, or $625/month.
- If you’re making $100k/year, that’d mean investing $10k to $20k every year.
TWO MORE PIECES OF FOOD FOR THOUGHT
On your enrollment form, it asks how much you want to contribute. Here, you usually have the option to write a specific dollar amount or a percentage. ALWAYS write the percentage! That way if you get a raise, the % stays the same but the $ amount goes up; ie. you're automatically upping your contributions with zero effort on your part. AND you won't be tempted to spend all of your new money.
- For example, if you contribute 10% of $50k, that’s $5000. But then you get a raise to $55k. 10% of your new salary would be $5500.
Secondly, AUTOMATE it. If you have your contributions automatically deducted from your paycheck before it hits your bank account, you won’t even miss it. Pay your future self first.
Remember, by investing money for your future, you’re essentially paying yourself now to do whatever you want down the line. What else would pay you to do exactly what you want to do, when and where you want to do it, for possibly 30 years? Nothing that I can think of!
So when you’re putting that little bit away every month, think of each contribution as a drop in your #financialfreedom bucket. Or think of each monthly contribution as its own snowball at the top of a hill. The more snowballs you have, the bigger they are at the top, and the longer they have to roll down the hill, the more secure you’ll be when you want to retire.
Click here for step-by-step instructions on how to use a reverse retirement calculator. This nifty tool helps you estimate how much you should be saving every month to make sure you reach your retirement goals!