How much should I contribute to my 401(k)?
So your employer offers a 401(k) and you’ve taken the first steps towards setting up an account and contributing. But now you’re wondering if you should simply set it and forget it, or if it’d be wise to increase your contributions every once in a while. No matter your current financial situation, here are some key things to consider when figuring out how much to contribute to your 401k.
Know your limits
In 2020, individuals can contribute up to $19,500 between their traditional and Roth accounts. If you’re 50 or older, you can contribute an additional $6,500 ($26,000 in total). If you are at the point where you are able to contribute the maximum amount in 2020, you’re off to an excellent start. You should note that the IRS does increase the maximum limit every year, therefore you should continue to save to the limit if you are financially able to.
Get the maximum match
If your company matches, you should always contribute at least enough to get the full match amount every year. Here’s an example of what that might look like:
If your company has a 100% up to 5% match, this means they will match you dollar for dollar, up to 5% of your pay that you deposit into your 401(k) account. If you make $100,000, you will need to contribute at least $5,000 to get the maximum match of $5,000 annually. If you don’t contribute at least $5,000, you will be leaving money on the table that otherwise would have been yours. Don’t cheat yourself out of this money! Your future self will thank you.
If you are only contributing the minimum to get the maximum match, keep aware of any increases your company may make to their matching contributions. If you can, you should increase your contributions accordingly to continue to receive the maximum match.
Figure out how much money you need in retirement
An often cited rule of thumb is to save 10-15% of your income for every year you work to have enough for a comfortable retirement. For a person making $50,000 per year this would mean saving $5000 to $7500 per year. Financial advisors usually want to be more precise with the calculation saying that you’ll need 70% of your current pay for every year in retirement (indexed for inflation).
Start lower and increase later
If you find that you can’t contribute as much as you think you will need based on what’s outlined above, because of your living expenses or debts, figure out what you can contribute. Start by making a budget. Separate out your necessary expenses (e.g. rent, utilities, groceries) from your discretionary expenses (e.g. dining out, entertainment) and see where you can decrease your discretionary spending. Based on your budget, look to contribute as much as you feel comfortable with.
You can also look to increase your contributions later on, consider doing so when you get a raise, a promotion, or on a set periodic basis. For example, you could increase your contributions by 1% each year until you reach 15% of your pay or you could increase one percent for every 4% you get in compensation increases. It's important to start saving as early as possible.
401(k) contributions and market volatility
During a market downturn, it’s important to take a step back, and recognize that when saving in your 401(k), you are investing for the long-term. Even though you might be afraid of investing in a volatile market, it’s actually a very good idea to continue to contribute to your 401(k).
Putting money into your 401(k) each pay period is a natural way to “dollar cost average,” which is a strategy where you invest a fixed dollar amount of money at regular intervals, over a long period of time. This means you won’t invest all your money into the market when it is either at a low or a high. With dollar-cost averaging, there is no wrong decision about when to invest in the market. In fact, while the market is at a low you could actually receive a better deal on buying investments.
Of course, when the market stumbles, it can mean the economy isn’t doing well, so it’s important to reassess the personal impact on your budget and expenses too. You should take a look at your whole financial picture to strategize how you can continue to save, and continue your regular 401(k) contributions to smooth out your returns over time.