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The standard rule of thumb is to contribute no less than 10 percent of your gross income to your retirement savings plan. However, there’s no such thing as a one-size-fits-all rule for retirement savings. How much you contribute to your individual retirement account (IRA) or 401(k) plan ultimately depends on your age, income, expenses, and goals.
We’re often asked, “How much should I contribute to my 401(k)?” by our readers. Unfortunately, this question never lends itself to a simple answer. Before we delve into the specifics, let’s first ask ourselves what we can contribute to our retirement savings plan before we ask what we should contribute.
What Are the Maximum Contribution Limits?
Employees who participate in an employer-sponsored 401(k) plan (or, alternatively, a 403(b) or 457 plan) are allowed to contribute up to $19,500 in 2020, which represents a $500 increase from the prior year’s limit. However, catch-up contributions are available to employees above the age of 50 who contribute to these plans. For those who qualify for a catch-up, plan holders can contribute an additional $6,500 per year. This applies to 401(k) plan holders as well as traditional or Roth IRAs.
Therefore, if we divide the per annum contribution limits by twelve to find our monthly contribution limits, we get $1,625 for the average investor. However, those over the age of 50 may qualify for a catch-up contribution for their 401(k), which would bring their monthly limit to $2,167.
Consider Your Time Horizon
An investor’s age should influence how much they put away for their retirement every month. For example, a 28-year-old who plans to retire at age 65 will save for 37 years before they start withdrawing from their IRA or 401(k). If this individual maxes out their 401(k) contribution every year at $19,500 ($1,625 monthly) over a 37-year time horizon and an assumed 7% average annual return, they will have over $3.1 million by the time they retire.
Although we would all love to retire with over $3 million in retirement savings, we should ask ourselves whether this is more than we need to achieve our desired lifestyle in retirement. Before deciding on how much to save every month, consider your time horizon (i.e., the number of years remaining before you plan to retire) and how much of your income you would like to replace with your retirement savings withdrawals and Social Security.
Max Out Your Employer’s Matching Policy
Many employers offer 401(k) contribution matching. At the very least, you should be contributing enough to your retirement savings to reach the maximum match offered by your employer. Therefore, an investor’s minimum contribution will depend on the specifics of their employment contract. In many cases, the contribution maximum caps out at around 3 percent of an employee’s gross salary—or up to 50 cents on the dollar of the first 6 percent of an employee’s contribution.
Everyone, regardless of their age or income, should take advantage of their employer’s 401(k) contribution matching plan. After all, it’s basically free money, so you should always aim to ramp up your contribution such that you maximize your employer’s co-contribution.
Is An IRA a Better Option?
If you’ve hit your employer’s 401(k) match, you might be better off investing additional cash into your IRA instead. Although IRAs have significantly lower contribution limits ($6,000 per year; $7,000 for those over the age of 50), IRA contributions can be made with after-tax dollars, and IRA accounts can be held by custodians such as brokerages.
Retirement investors looking to minimize risk by diversifying their portfolio should consider funding an IRA over a 401(k) because IRAs allow for many different asset classes to be held within the same account. These include stocks, bonds, precious metals investments, and even cryptocurrencies and real estate. One of the benefits of a 401(k), on the other hand, is that they often have lower expense ratios if you’re investing in traditional finance markets through an employer.
Don’t become complacent with merely hitting your employer’s contribution match limit and leaving it at that. If your employer’s contribution caps out at half of the first six percent of your salary, you should consider this benchmark to be the bare minimum.
For those who have other resources, such as an inheritance or passive income stream, it may be feasible to contribute to one’s 401(k) only to the point of hitting their employer’s contribution limit. However, the average investor should save beyond their employer’s contribution matching cap to accumulate a larger, more comfortable nest egg for their retirement.
Generally, between 10 and 15 percent of an individual’s gross income should be earmarked for retirement savings. However, the exact dollar amount that an individual should contribute to their 401(k) or IRA will depend mostly on their age and what percentage of their income they would like to maintain during retirement.