What percentage should I contribute to my 401k?

One of the common ways of saving for retirement is through a 401(k) plan. If your employer offers a 401(k), you should join and start making contributions towards your retirement. While there is no rule on how much you should contribute to a 401(k), you should consider contributing as much as possible to max out your contributions.

Financial advisors recommend contributing 10 to 15% of your salary into a 401(k) plan up to the annual contribution limit. The ideal contribution percentage depends on age and your take-home pay. For example, if you have a few years remaining to retirement, you should contribute a higher percentage of your salary to catch up. Also, if you have other monthly payments, you should consider the remaining take-home pay, and contribute the amount you can afford.

How much can you contribute to 401(k)?

Before determining how much to contribute to a 401(k), you should understand the annual IRS contribution limits.  If you are younger than 50, you can contribute to the 401(k) account up to $19,500 in 2021. If you are above 50, you can contribute up to $26,000, which includes $19,500 plus an additional $6,500 in catch-up contributions.

If your employer offers a company match, it will make additional contributions to your 401(k) above the employee’s limit. For 2021, the combined employee-employer contribution limit is $58,000 if you are below 50, or $64,500 for individuals who are above age 50.

Employer matching contributions

If your employer offers a match, you should contribute enough to get the maximum match since it is free money. A common formula for the employer’s match is to match 50 cents up to one dollar for every dollar contributed, up to 6% of the employee’s salary.

If an employee contributes 6%, and the employer matches the contributions dollar-for-dollar up to 6%, it means the employee will be saving a total of 12% per year. You can increase or decrease your contributions later on.

If your employer does not offer a 401(k) match, some employees choose to contribute to both a 401(k) and IRA. You can contribute to the IRA to up the annual limit of $6,000 in 2021 if you are below 50, and then contribute to the 401(k) up to the annual limit.

Factors that determine your 401(k) contribution percentage

The right 401(k) contribution percentage will depend on the following factors:

Age

When you start saving in your 20s, you will have a longer time to grow your retirement assets through compounding. If you start saving 10% of your salary in your 20s and increase the percentage gradually, you will have an impressive sum in your retirement. However, if you start saving in your 40s, you will need to contribute a higher percentage of your salary to catch up with your retirement contributions.

How much you will need to retire

If you want to maintain your living standards after retirement, you will need at least 80% of your pre-retirement income. You will need to consider all your other incomes in retirement such as 401(k), social security, pension, and rental income, etc. to determine how much to contribute to meet your retirement goals.

Take-home pay

If you have other payments such as credit card payments and student loans, you should only contribute the amount you can afford. Start by calculating all your monthly payments to determine how much of your salary remains, and how much you can afford to contribute to a 401(k).

Your 401(k) balance

If you have built a large nest egg, you will generally need to contribute an average sum to your 401(k). However, if you have a small 401(k) balance, you will need to increase your contribution percentage to catch up with the desired amount of retirement savings.

The Power of Compounding

If you start saving for retirement early, you will allow your money more time to grow. Retirement savings held in a 401(k) grow through compounding, which are the earnings you make on your 401(k) interest. When your 401(k) savings start earning a return, these returns will grow at an accelerated rate.

Compound interest works well when funds are left to grow over a long time. What starts as a small contribution to a 401(k) could grow exponentially over several decades. For example, if you are 20 and you want to retire at age 60 with $2 million, you will need to contribute $316.25 per month for the next 40 years to achieve this target.

However, if you wait until you are 30, you will need to contribute at least $884.75 per month for the next 30 years to achieve the $2 million target. If you start saving at 40, you will need to contribute at least $2,633.75 per month for the next 20 years to achieve that target.