401(k) Tips

How much should you contribute to 401k?

If you recently started a new job, find out how much you should contribute to 401(k), and what you can do to maximize your retirement savings.

3 min read

If you recently signed up for your employer’s 401(k) or moved to a new job with a 401(k) option, you should decide how much to contribute to your 401(k). The amount you decide to contribute will be automatically deducted from your paycheck, and it will determine the total retirement savings you will have in retirement.

Retirement experts recommend contributing 10% to 20% of your income. The IRS has a contribution limit of $19,500 in 2021, and an additional catch-up contribution of $6,500 if you are 50 or older. If your employer offers a match, the total employer and employee contributions should not exceed $58,000 in 2021.

The rule of the thumb in 401(k) investing is to contribute enough to get all of the matching dollars offered by your employer. Whether your employer offers a percentage or whole dollar matching, you should not leave free money on the table. Generally, the actual amount you should put in your 401(k) may depend on the following factors:

  •  Your age
  • How long you plan to work
  • How long you will be in retirement
  • The employer’s match
  • Catch up contribution option for employees over 50
  •  Other sources of income in retirement

How Much Can You Put in a 401(k)?

The IRS sets contribution limits for elective deferral contributions every year. For the years 2020 and 2021, the elective deferral for workers who contribute to a 401(k) or 403(b) is $19,500. The limit for 2019 was $19,000. This contribution limit applies to workers who are below age 50.

If you are above 50, the IRS allows catch-up contributions to help you compensate for the years you did not contribute to a 401(k) plan. For 2020 and 2021, IRS allows catch-up contributions of $6,500. Including the employer's match, the amount of annual 401(k) contributions cannot exceed $58,000 in 2021 or $57,000 in 2020.

Contribute Pp to the Employer’s Match

If you have recently started a new job, you should figure out if your new employer has a 401(k) matching program, and how much benefit is offered to employees. Usually, an employer may match your contribution up to a whole dollar or as a percentage of your salary.

For example, if the employer offers a 100% match up to 5% of your salary, you will need to contribute 5% of your paycheck to the 401(k) plan to get the maximum employer's match. This means that you will contribute 5% of your gross salary, and the employer will match an amount equal to 5% of your income. This means you will be putting away 10% of your paycheck every month towards your retirement savings.

Assuming that your annual gross income is $80,000, you will need to contribute $4000 to your 401(k) plan to get the entire employer’s match. The employer will match 100% of your contribution up to 5% of your gross income, which equals $4000. Therefore, you will be tucking away $8000 in 401(k) contributions every year for the period you will be working in the company, assuming the employer’s match does not change.

What Portion of Your Income Should You Contribute to Your 401(k)?

If you have set aside some money in your emergency fund, you should be comfortable contributing as much as you can. Once you are retired, you will need to live a comfortable life, and this means that you should maximize your contributions now to help you enjoy your retirement comfortably. Whether you plan to retire living a nomadic lifestyle, running an e-commerce business, or spending time with your family, you will need to have sufficient money to meet your living expenses. You should also consider your medical expenses in retirement especially if you have a long-term illness.

Most retirement experts recommend saving 10 to 20% of your gross income towards your 401(k) fund. As you age and climb the career ladder, you should continue increasing the contribution to help you invest the money in the various investment options offered by your employer, and grow sufficient savings before you can start taking the required minimum distributions. If you are spending your extra income on unnecessary purchases, you should find a way to reduce frivolous spending, and put the money in your 401(k) retirement fund.

The Power of Compound Interest

If you start contributing to your retirement fund in your 20s, your savings can compound to a generous sum by the time you reach retirement age. Compound interest is the interest you earn on the interest earned on your retirement savings, which can grow at an accelerating rate over the years. A person who started contributing at 40 will need to save more each year to achieve the same growth attained by retirement savers who started saving in their 20s.

For example, if you want to retire at 60 with a $2 million retirement fund, you will need to put a different level of effort, depending on your age. A person who starts saving at age 20 will need to contribute $316.25 every month to retire with a retirement fund of $2m at 60. In contrast, a person who starts contributing to a retirement fund at 40 will need to contribute $2,633.76 every month to achieve the same result.

If You are Older, Save More

Age is a key factor in determining how much you should have in your 401(k). If you start saving later in life, say in your 40s or 50s, you need to save more to make up for the years not contributed. You should contribute at least 15 to 20% of your income towards your 401(k) plan and work on accumulating enough savings to be comfortable in retirement.

If you are age 50 and older, you have an opportunity to increase your 401(k) contributions beyond the IRS contribution limits. You should take advantage of the catch-up contributions i.e. $6,500 for 2021. This means you can make the regular contribution up the IRS limit of $19,500 (for 2020 and 2021), make a catch-up contribution of $6,500, and still get a 100% employer's match if your employer offers this benefit.

Consider the IRA and Roth IRA Option

If your company does not offer an employer’s match, or if you have additional cash to save, you should rollover to an IRA, either a traditional IRA or Roth IRA. An IRA offers greater control to retirement savers, and you have access to a wide pool of investment options. However, an IRA has a lower contribution limit of $6,000 a year, and a catch-up contribution of $1000 for those age 50 or older.

A traditional IRA is a tax-advantaged retirement account, and you will not pay taxes on the contributions you make. The money grows tax-free, but you will owe taxes when you withdraw funds. With a Roth IRA, you pay tax on the contributions you make to the retirement plan. You don’t pay taxes on the investment returns and distributions. Therefore, Roth IRA money is more valuable in retirement since you won’t be required to pay taxes in retirement.