When it comes to the question of how much a person should contribute to their 401(k) account, the best answer is usually as much as they can. But that amount may differ based on your age and current financial circumstances. Additionally, the pre-tax annual contribution limit for 2021 is $19,500, although older workers may add more.
Most employees contributing to a 401(k) at work typically contribute a certain percentage of their salary up to the annual maximum allowed. Many financial advisors recommend deferring between 10 and 15 percent of your salary into a 401(k), but the percentage that is right for you depends on the following three factors:
1. Your age: The earlier you start contributing the better, due to the compounding effect of money. The fewer years you have between now and when you plan to start tapping into your 401(k) in retirement, the higher the percentage of your salary you should contribute for the years you remain in the workforce.
2. How much of your take-home pay you can afford to contribute: This is particularly important if you are also responsible for student loans or car loans, mortgage or rent, child or doggie day care or perhaps even medical bills.
3. Understanding what your retirement will look like and your retirement goals: Maintaining your current standard of living after retiring requires about 80 percent of your pre-retirement income. This is called a replacement ratio, and common sources of retirement funds in addition to your 401(k) include social security, pensions, IRAs, income from rental properties and inheritances. Having a realistic retirement goal is important and can impact your contribution decision.
How much can you contribute to a 401(k)?
The IRS places contribution limits on 401(k)s: For 2021, the contribution limit is $19,500, with an additional $6,500 allowed in catch-up contributions for workers who are age 50 or older.
How soon you are eligible to join your employer’s 401(k) depends on how the plan has been set up. Some plans allow employees to join on the first day of employment, but other plans may require up to a one-year waiting period. If your employer’s plan has a waiting period, consider setting up an individual IRA so that you can start saving right away.
Employer matching contributions
For employees who work at organizations that provide a 401(k) match, the IRS limits noted above do not include employers’ contributions. If your employer does provide a match, you should try to contribute at least as much as the company will match, since this is basically “free money.”
A common match formula is 50 cents for each dollar saved, up to 6 percent of pay. So if an employee contributes 6 percent and the employer contributes 3 percent, the employee is actually saving a total of 9 percent per year.
If your employer does not offer a match, some employees have found it to be a smart move to first contribute the maximum to an IRA, and only then begin contributions to their company’s 401(k).
Pay tax now or later when contributing to your 401(k)
When you sign up with your employer’s 401(k), you will need to decide if your contributions will be pre-tax or after-tax, that is, whether they go into a traditional 401(k) or a Roth 401(k), if your employer offers a Roth option.
Saving on a pre-tax basis means you are deferring the tax liability on your contribution until after you retire. As an example, a worker aged 50-plus in the 12 percent tax bracket (married filing jointly) with $80,000 in taxable income who defers the maximum for 2021 – $26,000 – will reduce their tax bill by $3,120.
Saving for retirement on an after-tax basis in a Roth 401(k) means you pay taxes on your contributions now, at your current tax rate, so that when you access the money during retirement, the withdrawals will be tax-free as long as funds have been in the account for a minimum of five tax years.
If your employer plan allows, you can take advantage of both types of contributions to diversify your tax position at retirement.
When determining your contribution percentage, consider automatic boosts
In 2019, the average 401(k) contribution was 7 percent of pay, according to Vanguard 401(k) data. Meanwhile, only 21 percent of 401(k) participants saved more than 10 percent of their salary for retirement.
If you can’t afford to contribute that much initially, many employers will allow you to increase your contribution percentage automatically each year (up to a maximum of 10 percent), which may be a more comfortable and gradual way to increase your contribution amount.
A 401(k) can be one of your best tools for creating a secure retirement. But you may want to also consider some retirement investing alternatives.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.