Saving for retirement is important. We all know that but how exactly does one save for retirement? If you work for a for-profit company, one great way to save is through your employer’s 401(k). But what percentage of salary should you save in your 401(k)? If you read the advice from financial experts, you’ll see varying percentages. You’ll also see the ever-helpful “it depends”. So let’s consider some general advice that will help you think about just how much you should save.
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A Quick Review of 401(k)s
A 401(k) is a retirement savings plan offered by many for-profit companies. They grew in popularity in the 1980s while pensions decreased greatly in popularity. With a pension, the employer would put a certain amount of money into a fund every year and then the employee would receive pension payments once they retired. Pensions were expensive for employers so they eventually switched to a 401(k), which put the onus on the employee to save money.
With a 401(k), your employer chooses some investment options, and then it is up to you to create a portfolio. That portfolio is where your retirement savings will grow instead of a pension. A 401(k) allows you to decrease your taxable income because you fund it with pre-tax dollars, but it’s also risker because it relies on the market. If the market performs poorly, your 401(k) could potentially lose money. A 401(k) is still a good way to save for retirement, but what percentage of your salary should you actually put into it?
How Much Should You Contribute to Your 401(k)? – Rule of Thumb
As a rule of thumb, experts advise that you to save between 10% and 20% of your gross salary toward retirement. That could be in a 401(k) or in another kind of retirement account. No matter where you save it, you want to save as much for retirement as you can while still living comfortably.
It’s important to say that this is just a general rule. The actual amount you should save depends on your individual situation. For example, if you are 50 years old and don’t have any retirement savings, you should save more than 20% of your gross annual salary. If you’re 30 years old and already have $100,000 in retirement savings, you could probably decrease your contributions for a bit in order to pay off a mortgage or loan. It’s difficult to create a one-size-fits-all plan because everyone is in a different place with their finances.
Saving 10% to 20% of your salary every year might sound like a lot. It is. Luckily, you don’t have to do it all at once. You can spread your contributions out over the year and you can contribute more or less some years. You also don’t have to save all that money through your 401(k).Let’s take a step back and talk about other factors you should consider when you think about how much to contribute to your 401(k).
Your Emergency Fund
You want to save as much as you can for retirement but you shouldn’t put all of your savings toward retirement. You should always have enough cash reserves to cover necessary expenses like food and rent. It’s also a good idea to create an emergency fund.
An emergency fund will protect you from unexpected expenses or difficult financial situations. What would you do if you lost your job or didn’t have a regular salary for a month? What if a family member got sick and you had medical bills to pay? A strong emergency fund allows you to get through tough times. Withdrawing money from your retirement accounts should be an absolute last resort. Just as importantly, an emergency fund will ease your mind by providing a sense of security. It’s always nice to know that you have a backup plan in case something goes wrong.
Again, there is no perfect answer for how much you should have in an emergency fund. It depends on your situation. In general though, you want enough to cover at least a few months of expenses. That may sound like a lot if currently have no emergency fund, but you can build your fund over time by adding a little each week or month.
An Employer Match
You have enough saved up to cover your expenses. You emergency fund is there in case you need it. Now you’re starting to think about 401(k) contributions. Where do you you start?
The first thing you should figure out is if you have an employer matching program with your 401(k). With an employer match, your employer will match your 401(k) contributions up to a certain percentage of your gross salary. For example, say your employer offers 100% match on the first 5% you contribute. That means if you contribute 5% of your gross salary to your 401(k), your employer will contribute an amount equal to 5% of your gross salary. The total contribution to your 401(k) would then equal 10% of your gross salary.
An employer match allows you to instantly increase your contribution and you should always take advantage of matching programs. Unfortunately, many people pass up free money by not covering their employer match.
Other Retirement Savings
If you remember the rule of thumb earlier, experts advise saving 10% to 20% of your gross salary each year for retirement. You could put this all in your 401(k), but you should consider some other options once you cover your 401(k) match.
If you qualify for a Roth IRA, it’s a good idea to make the maximum contribution (which is $5,500 per year if you’re under 50). A Roth IRA uses after-tax money, so it won’t lower your taxable income like a 401(k). The difference is that you don’t need to pay income tax when you withdraw the money from a Roth IRA. It’s good to have a mix of taxable and non-taxable income in your retirement.
Roth IRAs are particularly useful for young people who are just starting their careers. Chances are that if you just graduated college, you’re in a lower tax bracket than you will be in when you retire. Paying the income tax now instead of later can save you money.
Some employers offer a Roth 401(k). The Roth 401(k) started in 2006 and its popularity is growing. It takes after-tax money just like a Roth IRA, but has a much higher contribution limit of $18,000. Contributing to a Roth 401(k) is a good idea if your employer offers it.
If your employer doesn’t offer a 401(k) you should look into a traditional IRA. A traditional IRA allows you to contribute pre-tax dollars and lessen your taxable income just like a 401(k). Some people also have an IRA because when they left a previous employer, they moved their 401(k) funds into an IRA via an IRA rollover.
How Much to Contribute to Your 401(k)
You have emergency savings. You met your employer’s 401(k) match and then you maxed out a Roth IRA (if you qualify). OK, let’s get back to the main question. How much should you contribute to your 401(k) now?
Your goal at this point should be to save as much as you can for retirement while still living comfortably now. For some people that will mean another 1% of their salary into their 401(k). For others it will mean maxing out their 401(k).
The key is to actually put as much as you can toward retirement. Some people spend their money frivolously, save only a little bit and then tell themselves it’s OK because that’s the best they can do. If you’re spending thousands of dollars every month on unnecessary purchases, you should find a way to cut that spending and put it toward retirement instead. (A budget could really help you cut unnecessary spending.) It might not sound fun, but remember that the goal is to have financial security when you retire.
Experts advise saving 10% to 20% of your gross salary each year, but that’s just a general rule. Your goal should be to save as much for retirement as you can. Before anything else, you should ensure that you have enough in savings to cover regular expenses and emergencies. If you have an employer match on your 401(k), you should contribute enough to cover the full match. If you qualify for a Roth IRA, you should try to max it out. It’ll provide a source of nontaxable income in your retirement. Once you’ve done those things you should contribute as much to your 401(k) or IRA as you can.
The most important thing is to contribute regularly – even if you can only save a little bit. It’s hard to prioritize your future over the things you want now, but you will thank yourself if you save while you’re young. If you’re struggling to get started or stay on track, consider working with a financial advisor. A matching tool like SmartAsset’s can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to up to three registered investment advisors who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
Tips for Contributing to Your 401(k)
- If you switch jobs, you can no longer contribute to a previous employer’s 401(k) plan. You don’t want to lose the hard work you did to save that money, so you should look to make a direct 401(k) rollover to your new employer’s plan.
- A traditional IRA and a 401(k) offer similar tax benefits. You might wonder whether one is a better option for you. Here’s an article to help you think about an IRA vs a 401(k).
- You should always avoid early withdrawals from your 401(k). Not only will you have to pay the income tax, you’ll have to a pay 10% penalty. There are a couple of ways you could avoid that big penalty though. If you really think you need to withdraw money early, here’s more information on 401(k) withdrawals.
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