How to Choose the Right Contribution Percentage to Your 401k Retirement Plan
By David Bakke
David Bakke writes about money topics like saving money, planning for retirement, smart shopping, and building wealth on the Money Crashers personal finance blog.
If your employer offers an individual 401k retirement plan, you should be contributing to it unless you fall into a very small exception category. The only time I would advise against participating in a company-sponsored 401k plan is if these contributions would interfere with your ability to pay monthly bills or get out of debt. Don’t invest in your future at the expense of your current situation. But if you can afford to make even a small contribution to the plan, go for it. Now that you're considering your personal retirement planning, let's address a crucial question: How much should you contribute to your 401k fund? Is 1% enough? Should it be 5%? Or 10%? Should the amount of your contribution depend on your age? Consider these five key factors.
1. Your Company Match Offer
Many companies will match your 401k contribution up to a certain limit. If possible, contribute at least as much as that limit. This company match is completely free money and you should take advantage of every penny of it. If you don't, you're leaving money on the table. The match limit varies, so check with your company to find out whether or not you are making the most of your 401k investment. Also, make sure you read the fine print: Don't be surprised if your company only matches half of your commitment. Many employers also require a minimum amount of service before their matching contributions are fully vested. If you want to consider contributions that exceed your company match limit, the benefits of your higher percentage contribution begin to drop significantly. At this point, you need to weigh the value of the additional 401k investment against the importance of funding other aspects of your life.
2. Your Limit and Your Company’s Limit
There is a limit on how much pre-tax income you can contribute to your 401k retirement plan. Maximum 401k contribution limits fluctuate from year to year, but currently, the limit set by the IRS is $16,500. Your employer may even opt to set a lower limit than that, and employer limits vary from company to company. I've seen them go as high as 20%, but normally, most companies set it around 10%. Some professionals advise that you should contribute the absolute maximum allowed under this rule. Find out your company's restrictions before you make a decision.
3. Your Age
Some say that the younger you are, the more you should contribute to your 401k. In essence, the contributions that you make at a younger age are more valuable than the ones you make as you grow older, thanks to the power of compound interest. However, keep in mind that money contributed to a 401k is less accessible than money invested in say, a Roth IRA account, where you can withdraw your contributions at any time without penalty. At a younger age, you may have greater need to spend money to further your education, buy a home, or make other stage-of-life investments. The value of liquidity is an important factor for you to weigh against the benefit of compound interest. Personally, I think your contribution level should depend more upon your current financial situation than on your age. Your actual income level, your current level of debt, and your plans for upcoming life events (and corresponding need for money) should all play a far greater role in your decision-making process.
4. Your Personal Situation
Since your 401k contribution percentage has a lot to do with your personal situation, you owe it to yourself to consider your mindset toward your money and risk, and other more subjective factors. There are two schools of thought to consider when determining the right contribution percentage. According to one philosophy, you can begin with a large contribution and scale your percentage back as you see fit. Alternatively, you can start small and raise your percentage as much as you can over time. There are two reasons I prefer the first method. First, it's human nature to set something in motion and then forget about it. When it comes to your 401k, by starting high, you choose to commit a significant portion of your income to your 401k plan and receive the maximum benefit from your company match program. In the event that you never tweak it again, you will not lose out on potential gain because you forgot to ramp up your percentage. Second, while some employers will allow you to change your percentage at any time, others will only allow it at certain times of the year. As a result, if you go with the "start small" plan, it might take you a long time to work your way up to your peak percentage because of limits on how often you can change this allocation.
5. The Power of Compounded Interest
The benefits of a higher contribution are easy to see in purely mathematical terms. I've spent a few minutes with an online 401k contribution calculator to illustrate this point for a sample situation. Here are the parameters:
1. $50K salary
2. Age 35
3. Retirement age of 65
4. 8% return on investment
5. 25% tax bracket
In this example, increasing the contribution by just one percentage point would drop your monthly income by a mere $31, which is about $8 per week. Since you would be lowering your taxable income, your annual tax bill would decrease by about $125. So on an annual basis, roughly one-third of your increased 401k contribution would come right back to you at tax time. Are you ready for the big number? If you continue to make that additional monthly contribution until you retire, those contributions of eight dollars per week could grow to over $56,000, based on the 8% return on your investment. Say that a few times over in your head: fifty-six thousand dollars.
In the end, you can make this decision only after reviewing the facts of your current financial situation. And more importantly, as your life changes, you should reevaluate your contribution accordingly. There may be times in life when you’ll have to lower your percentage, but hopefully there are just as many times when you can raise it or maintain a target level. Take a few minutes out of your day to think about your own 401k. Do you know your percentage contribution or how to change it? It's up to you to plan for your future, and although retirement may seem like it's a long way off, there will come a day when you'll be glad you did.