How much should you contribute to your 401 (k)?

When it comes to how much someone should contribute to their 401 (k) account, the best answer is usually as much as they can. But this amount may vary depending on your age and current financial situation. Additionally, the pre-tax annual contribution limit for 2021 is $ 19,500, although older workers may add more.

Most employees who contribute 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% of your salary into a 401 (k), but which percentage is right for you depends on three factors:

1. Your age: The sooner you start contributing, the better, due to the cumulative effect of the money. The fewer years you have by the time you plan to start drawing down your 401 (k) in retirement, the higher the percentage of your salary you should be contributing for the years you remain in the workforce. .

2. How much of your net salary you can afford to contribute: This is especially important if you are also responsible for student loans or car loans, mortgage or rent, child or dog care, or maybe even medical bills.

3. Understand what your retirement will look like and your retirement goals: Maintaining your current standard of living after retirement requires about 80 percent of your pre-retirement income. It’s called a replacement rate, and common sources of retirement funds in addition to your 401 (k) include Social Security, pensions, IRAs, rental property income, and inheritances. Having a realistic retirement goal is important and can affect your contribution decision.

How much can you contribute to a 401 (k)?

The IRS imposes contribution limits on 401 (k): For 2021, the contribution limit is $ 19,500, with an additional $ 6,500 allowed in catch-up contributions for workers aged 50 or older.

The date you are eligible to join your employer’s 401 (k) depends on how the plan was set up. Some plans allow employees to enroll on the first day of employment, but other plans may require a waiting period of up to one year. If your employer’s plan has a waiting period, consider setting up an individual IRA so you can start saving immediately.

Employer matching contributions

For employees who work in organizations that provide a 401 (k) match, the IRS limits stated above do not include employer contributions. If your employer provides correspondence, you should try to contribute at least as much as the company will, as this is essentially “free money”.

A common matching formula is 50 cents for every dollar saved, up to 6% of salary. So if an employee contributes 6 percent and the employer contributes 3 percent, the employee actually saves a total of 9 percent per year.

If your employer doesn’t offer a match, some employees have found it a good idea to start by contributing the maximum to an IRA, and then start contributing to their company’s 401 (k).

Pay taxes now or later by contributing to your 401 (k)

When you sign up with your employer’s 401 (k), you will need to decide whether your contributions will be pre-tax or after-tax i.e. whether they will 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 defer tax liability on your contribution until you retire. As an example, a worker aged 50 and over in the 12% tax bracket (married jointly declaring) with taxable income of $ 80,000 which carries over the maximum for 2021 – $ 26,000 – will reduce their bill. tax of $ 3,120.

Saving for after-tax retirement in a Roth 401 (k) means you pay tax on your contributions now, at your current tax rate, so when you access the money during retirement, withdrawals will be exempt. as long as the funds have been in the account for at least five tax years.

If your employer’s plan allows it, you can take advantage of both types of contributions to diversify your tax situation at retirement.

When determining your contribution percentage, think about automatic increases

In 2019, the average 401 (k) contribution was 7% of salary, according to Vanguard 401 (k) data. During that time, only 21 percent of 401 (k) participants saved more than 10 percent of their paycheck for retirement.

If you can’t afford to contribute so much up front, many employers will allow you to increase your contribution percentage automatically each year (up to a maximum of 10%), which can be a more comfortable and gradual way to increase your contribution. ” increase your contribution amount.

A 401 (k) can be one of your best tools for creating a secure retirement. But you may also want to consider investment alternatives for retirement.

Learn more:

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 performance of investment products is not a guarantee of future price appreciation.