One of the most basic questions a 401k participant faces is how much should I allocate from my pay for 401k contributions?
Behavioral economists attempt to answer this question through complex analyses of personal behaviors, priorities, and opportunity costs. Why do some people select instant gratification over future needs? What causes people to use current income to pay for future needs (by saving) while others use future income for current needs (by borrowing). Answering the question in this fasion is beyond our scope.
We keep things simple and assume that reasonable people (who have Googled this question and found their way to our site) understand the general importance of saving for retirement. They are looking for practical guidance about their 401k contributions, not necessarily the theoretical underpinnigs of their behavior.
With that in mind, then, here are some practical tips to help you decide how much you should contribute to your 401k:
- Rule of Thumb 1: Contribute enough to max out any employer match. This rule applies to 401k participants at every age. If you make $40,000 and your employer offers a 50% match up to 6% of salary, you should contribute at least$2,400 to get the full available $1,200 employer match. Failure to get the full employer match is the equivalent of throwing retirement savings away. Employer matches are fast going away in this recession economy as companies pare costs. If you’re lucky to still have an employer match available to you, be sure to take advantage of the opportunity. A 25 year-old (using the sample figures above) could expect to have about $460,000 more in retirement savings at age 65, by fully leveraging the employer match. This 401k calculator allows you to compute amounts for your own situation.
- Rule of Thumb 2: Save a percentage that represents half your age. If you’re 20, save 10 percent; if you’re 40, 20 percent; if you’re 50, 25 percent, etc. This rule is particularly useful for people later in their careers who need to catch-up on retirement savings. For example, a worker who saves 10% at age twenty and consistently maintains this savings level over a their career would liklely accumualte an adequate nest egg at retirement without needing to ramp up contributions to 20% at age 40, etc.
- Rule of Thumb 3: Save 10% for basics, 15% for comfort, and 20% to escape. This rule of thumb comes from MSN Money and like Rule 1, applies to 401k savers of all ages, provided a retirement savings plan is started in your twenties. Late savers can adjust the savings rates proportionately using Rule 2 for the basic level:
- at age 40, save 20% for basics, 30% for comfort, and 40% to escape
- at age 50, save 25% for basics, 37.5% for comfort, and 50% to escape
- Rule of Thumb 4: Let your employer decide. With passage of the Pension Protection Act of 2006, more employers are adopting automatic enrollment 401k’s. Under these programs workers by default are placed into a 401k at a standard contribution rate set by the plan sponsor. In some automatic enrollment plan designs, 401k contribution percents ramp up annually in conjunction with pay increases. Default contribution rates themselves likley will not be adequate to fund a secure retirement. Still, for 401k particpants unable to make a decision, letting things go on auto-pilot is a better choice than doing nothing.
- Rule of Thumb 5: Save what it takes to reach 75% Retirement Replacement Ratio. The best answer to the question “How Much Should I Contribute to a 401k?” can come only from personalized analysis of your situation. This involves taking into account your age, savings, health status, dependents, other retirement income sources, risk tolerance, retirement goals, and myriad other personal factors. Expect to do considerable homework on your own or, possibly, hire an experienced independent fee-based financial consultant to help you. There are plenty of good, free resources to help you get started including the retirement calculator and 401k calculator found on this site.
Thanks to the folks at Earn What You Spend for including this article in their Carnival of Personal Finance. Check out the other personal finance articles as well.