How much should I put into my 401(k) each year?
Your 401(k) can be one of the most effective tools to turn today’s income into a secure future. How much you put into your 401(k) each year depends upon how much you are going to need to support your lifestyle after retirement, and what other sources of income you will have.
The other equally important question is when should I begin? Because contributions to your 401(k) are made with pre-tax dollars and compound tax deferred until withdrawn, there is arguably no more effective way to save for retirement. Many employers match contributions to a 401(k), so it is to your benefit to take full advantage of this benefit. Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
It is easy to justify not participating in your companies 401(k) when you begin your first job, given all the other expenses you are facing. Taking advantage of the opportunity that a 401(k) offers, sooner than later will have a dramatic impact on when you can retire, and what your retirement income will be.
You will often hear that there are only two certainties in life, death and taxes. I would offer that there is a third, less spoken of, that is retirement. Whether it is by choice or not, we will all spend some time in retirement. How we enjoy those years is controlled by decisions we make now. If you are willing to make some sacrifices to your lifestyle now, it may pay dramatic dividends in retirement.
A simple way to calculate how much you will need to have accumulated by the time you retire is to make this simple three step calculation:
- Determine what your annual income needs will be in retirement
- Chose a reasonable return on your investments.
- Divide #2 into #1 to calculate the amount of money you will need to have accumulated by the time you retire.
Example: If you need $50,000 of annual income in retirement, and believe you can generate a 5% return on your investments, you will need to have a nest egg of $1,000,000.
Okay, so now you ask, “How do I accumulate $1,000,000”. To demonstrate how compounding can work, we’ll do a simple calculation. If we invest $5,000 a year, starting at age 25, continue until we reach age 65, and assume an average return of 7.5% over this time period we would accumulate $1,136,282. Although no one can guarantee this rate of return for 40 years, the take away is that consistent, periodic investments, can accumulate significant balances especially if invested in tax deferred accounts, and left untouched until retirement.
The amount that the IRS allows an employee to put away each year is steadily rising. The 401(k) contribution limit for 2014 is $17,500 per year. Because the IRS recognizes that it is difficult for younger American workers to contribute a great deal in their early working years, there is a provision that allows workers over 50 years old to contribute an additional $5,500 per year to their 401(K). So in 2014 the maximum an employee who is over 50 can contribute on a pre-tax dollar is $23,000. If your cash flow allows it, I can’t think of a smarter way to save for retirement.
Next month we will discuss whether it makes sense to convert an Traditional IRA to a ROTH-IRA.