When planning for retirement, you want to have a strategic savings plan for how you manage your money rather than doing random monthly contributions to your 401(k) from your paycheck.
How exactly should your 401(k) factor into your overall retirement plan?
Like most financial decisions, there are a number of things to consider. We’ll walk you through how you can figure out how much you should contribute to your 401(k), as well as some other types of accounts to consider.
Understand How a 401(k) Works
A 401(k) is a retirement savings account sponsored by an employer. You typically make contributions directly from your earnings before you receive your paycheck and before taxes are taken out. Once you start taking withdrawals during retirement, you’ll pay taxes on your savings.
Oftentimes, an employer offers a matching amount, usually based on a percentage of your annual salary. For example, your employer match may be 3% and let’s say you make $60,000 a year.
If you contribute 3% of your salary ($1,800) then your employer will contribute the same amount to your 401(k). It’s almost always a good idea to max out that matching amount whatever it may be. Essentially, it’s free money — why pass that up?
401(k) Contribution Limits
Contributing to your 401(k) does come with limits. In 2020, the contribution limit is $19,500. That’s up from just $19,000 in 2019 so it’s good to check each year for any changes that may have been pushed through.
Still, even though you can contribute up to $19,500 to your 401(k) doesn’t mean you should. There are a number of other factors to consider, from your current finances to the future tax implications of your decisions.
Since taxes aren’t taken out of your 401(k) contributions (and earnings) until you make a withdraw, that burden can add up quickly.
Analyze Your Current Finances
Once you’re contributing enough to your 401(k) to max out any employer contributions, take a step back and look at the rest of your finances. Most importantly, consider your current debt load. If you have any high-interest debt, whether in the form of credit cards, loans, or both, then knock out those before you contribute any more to your retirement account.
You’ll save much more by avoiding paying all of that interest than what you’re likely to accumulate in your 401(k). Once you’ve taken care of that, it’s time to create an emergency fund if you don’t already have one. For short-term emergencies, it’s good to have $1,000 in an easily accessible account.
You should also consider saving a larger amount for a longer-term emergency, such as unemployment or going through an unexpected medical event. Experts often recommend having between three and six months of your expenses on hand for these types of situations.
Once you get your short and mid-term savings on track, you can direct any extra income towards additional retirement accounts. But before you get aggressive with your retirement planning, make sure your current financial house is in good shape. A strong foundation is essential before building on your savings for retirement.
Estimate Your Retirement Needs
A smart way to think about your 401(k) contribution is to figure out how much money you expect to need once you reach retirement. Many financial advisors recommend the 4% rule. That refers to withdrawing 4% of your total savings each year of retirement.
Let’s look at this theory with some example numbers.
If you have $1 million in savings, you should be able to withdraw 4% of that each year and have enough to last you through your retirement. That comes to $40,000 a year. For some people, that may be plenty to live off of, and for others, it may be a stretch.
Play around with the numbers to figure out your savings goal, then pop some numbers into a retirement calculator to determine the annual amount you should be squirreling away. You can also experiment with how early or late you want to retire by and how much you expect from Social Security.
Remember that you may not need the same amount of money you live off of now by the time you retire. It all depends on what you want to do when you retire and what type of expenses you might need then. Take a holistic approach to both saving and reducing expenses to determine exactly how much you’ll need.
Consider Opening an IRA
Once you figure out how much you want to save each year to meet your retirement goals, think about all of the retirement account options that are available. Obviously, you want to contribute to your 401(k) as much as your employer will match. That automatically adds a big chunk of cash to your portfolio without costing you a dime.
Beyond that, though, you should consider investing in an IRA. There are two types: a traditional and a Roth IRA. Like a 401(k), a traditional IRA allows you to invest with pre-tax dollars, saving the tax burden to when withdraw time comes.
A Roth IRA, on the other hand, is funded with your money after you’ve paid taxes on it. The plus side is that once you retire and start taking withdrawals, you won’t have to pay any taxes at all. That includes all of your earnings, which have hopefully accumulated significantly over the years.
In addition to diversifying your tax impact (which we’ll talk more about shortly), investing in either type of IRA can offer a lot more variety in your investment options. Many employers’ 401(k)s have limited offerings so you can gain access to different types of stocks.
There are some limits to how much you can contribute to an IRA, however. For 2020, the annual contribution limits are as follows:
- Age 49 and under: $6,000
- Age 50 and older: $7,000
When you think of that annual contribution goal, consider directing a portion of it to an IRA.
Understand the Tax Impact of Your Contributions
We talked about the tax differences between 401(k)s, traditional IRAs, and Roth IRAs. So why is it important to spread out your retirement savings?
Let’s walk through it.
Depending on where you are in your career journey, you may be making less or more than what you plan on withdrawing each year during retirement. If you’re earning less money, it makes sense to focus your retirement contributions on taxable accounts like the 401(k) and traditional IRA because you’ll enjoy a lower tax rate.
Once you expect that you’re earning more than what you’d withdraw in retirement each year, consider putting more into a tax-deferred account like your Roth IRA. That’s because you’ll be taxed later on when you’re making a smaller amount of money.
It may seem complicated, but it’s great to start thinking about how you can maximize your tax advantages now and save on your future tax bill during retirement.
Increase Your Savings Goal
When figuring out your overall retirement contribution goal, some financial advisors recommend tucking away 10% to 15% of your income. Going back to that $60,000 annual income example, that comes to $6,000 to $9,000 each year, which you can spread out across your 401(k) and IRAs.
But once you get your debt under control and your liquid savings accounts padded, think about growing that percentage even greater. This is especially true if you’ve just started saving for retirement rather late in the game.
If you’re in your 30s or 40s, for example, you’re closer to retirement age than someone fresh out of college at 22. You’ve lost a few years of that compounded annual growth. Instead of worrying about how to build your nest egg, make the commitment to put away as much as 20% to 25% of your income — or more, if you can afford to. To stay on track, you may want to consider working with a financial advisor.
There’s always a balance of living well now and preparing for an enjoyable future. Think of how you can bridge the gap between the two so that you’re not eating ramen every night for 20 years but also so you don’t worry about how you’re going to take care of yourself when you’re older.
More and more Americans are working later to prepare for retirement. While that’s ok, make sure you put yourself in a position to make those decisions out of want, rather than out of need.
Contribute enough to your 401(k) to max out your employer’s match, and diversify your retirement accounts so you won’t have a huge tax burden further down the road.