Employer-sponsored 401(k) scheme is among the most commonly used methods to save to fund retirement. For many employees, it is the only saving account for retirement.
It’s common to be concerned and have questions in regards to savings for your retirement. The question that is asked most frequently is “How much should you contribute to your 401(k)?”
Like all financial decisions, there are many factors to be considered. We’ll first walk you through the steps to determine the amount you can make contributions towards the account known as your 401(k). We’ll then show you different types of accounts you should take into consideration.
Understand How a 401(k) Works
A 401(k) is an employer-sponsored retirement savings account. Until you receive a paycheck, you usually contribute directly from your earnings, minus taxes. However, once you start making withdrawals during retirement, you will have to pay taxes on your savings.
Often, your employer will offer a matching amount, usually based on a percentage of your annual salary. For example, your employer match might be 3%, assuming you make $60,000 per year.
If you contribute 3% of your salary ($1,800), your employer will contribute the same amount to your 401(k) account. So it’s always a good idea to maximize the employer match, whatever it is. Essentially, it’s free money – why give it up?
401(k) contribution limits
Making contributions towards your 401(k) is subject to limitations. The 2022 maximum contribution is set at $20,500. The limit is up from $19,500 for 2021. It’s a good idea to review each year for any adjustments that might have been put through.
However, just because you can contribute as much as $29,000 to your 401(k) does not mean that you have to. There are a variety of other factors to take into consideration, ranging starting with your current financial situation and the tax implications in the future of your decision.
Because taxes aren’t deducted from the 401(k) contribution (and the earnings) until you take an withdrawal, the tax cost can quickly mount up.
Analyze Your Current Finances
After you’ve made enough contributions towards the 401(k) to be able to take full advantage of the employer contribution then take the time to take a look at the other aspects of your finances. Consider the amount of debt you have. Make sure you get rid of all debt with high interest prior to contributing more money to your retirement savings account including loans or credit cards.
You’ll save more money in the long run by not paying any of those interest costs than you’re likely accumulating within the 401(k). Once you’ve dealt with this, you’re now ready to establish your own an emergency savings account in case you don’t have one. In case of emergencies that are short-term it’s best to have a minimum of $1,000 in an emergency account that you can access easily account.
It is also worth considering saving more money to cover a long-term emergency like unemployment or experiencing an unexpected medical emergency. Experts recommend keeping at least three to six months worth of expenses in reserve for the same types of scenarios.
After you have your savings in the short and middle-term on track, you are able to use any extra earnings to fund more retirement accounts. Before you go all-in with your retirement plans be sure that your financial house is in good condition. A solid foundation is vital prior to establishing your retirement savings.
Estimate Your Retirement Needs
The best method to consider the amount of your 401(k) donation is to calculate the amount you’ll to require when you become retired. A lot of financial advisers suggest the four percent rule. This is the practice of taking the equivalent of 4% of your savings every year during retirement.
Let’s look at this theory with a few examples of numbers.
If you have a million dollars in savings and you are able to take 4% of it every year. You should have enough money to get you until retirement. This is equivalent to $40,000 per year. It could be enough to live on for some, but some could be too much.
Try playing around with the numbers until you figure out your savings goals. You can then input the numbers into an online retirement calculator to figure out how much you’ll need to be saving. It is also possible to experiment with the length of time you’d like to be retired and the amount you’re hoping to get to earn from Social Security.
Be aware that you may not require as much money that you currently have to live on by retirement. It’s all dependent on the things you’d like to accomplish when you retire and the expenses you may incur. Therefore, take a comprehensive method of saving money and decreasing costs to figure out exactly the amount you’ll require.
Consider Opening an IRA
After you determine the amount you want to put aside each year to achieve the goals of your retirement, consider all retirement options for your account. You should definitely make contributions to a 401(k) at the rate that your employer is willing to match. This will automatically add a huge amount of money to your account and doesn’t cost you a penny.
On top of that, you should also consider investing in an IRA. There are two types:Traditional and Roth IRAs. Like a 401(k), a traditional IRA allows you to invest pre-tax dollars to save on tax liabilities until withdrawal time arrives.
Roth IRAs
The Roth IRA, however is funded with your earnings after you’ve paid taxes for it. The benefit is that when you retire and begin withdrawing money, you don’t need to pay any tax whatsoever. This applies to all your earnings, which probably accumulated a lot through the years.
Along with diversifying your tax burden (which we’ll discuss in a moment) investing in either kind of IRA will give you more choice in investment choices. The majority of companies’ 401(k)s are limited in their offerings and you’ll be able to gain access to various types of stocks.
There are limits on the amount you can contribute to an IRA However, there are some limitations. In 2022, the annual contribution limit is according to:
- Age 49 or under: $6,000
- Age 50 or above: $7,000
If you are thinking of your annual goal for contributions, think about making a contribution towards an IRA.
Understand the Tax Impact of Your Contributions
We have discussed tax distinctions between 401(k)s, traditional IRAs as well as Roth IRAs. Then, why is it important to spread out your retirement savings?
Let’s take a walk.
Based on the stage you’re at in your career depending on your current position, you could earn the same or less than you plan to take out each year during retirement. If you make less and you are earning less, it is logical to invest in tax-deductible retirement accounts like the 401(k) and a traditional IRA since your tax rate is lower.
When you’re sure that you’re earning more than the amount you’d be able to withdraw each year in retirement Consider putting the extra money into a tax-deferred savings account, such as that of your Roth IRA. This is because you’ll be taxed later when you’re earning less money.
It’s not easy It’s a good idea to begin thinking about ways you can take advantage of your tax advantages today and lower your tax bill when you retire.
Increase Your Savings Goal
When determining your overall retirement contribution goals, some financial advisors recommend saving 10 to 15 percent of your income. Going back to that example of earning $60,000 a year, that’s $6,000 to $9,000 a year, which you can spread over your 401(k) and IRA.
But once your debt is under control and your liquid savings account is filled, you might consider increasing that percentage a bit more. This is especially true if you’re just starting to save for retirement.
For example, if you’re in your 30s or 40s, you’re much closer to retirement age than a 22-year-old fresh out of college. You’ve already lost a couple years of compound annual growth. Instead of worrying about how you’re going to save, save 20 to 25 percent of your income – and more if you can afford it. To stay on track, you may want to consider working with a financial advisor.
Bottom Line
There’s always a balance between doing your best now while preparing for a pleasant future. Find ways to make the connection between these two to ensure that you don’t have to eat the same ramen meal every night for twenty years. Also, think about how you’ll care for yourself as you age so that you don’t need to think about it.
A growing number of Americans are working longer hours to plan for retirement. While this is fine however, you must are in the position of making these decisions out of need instead of out of necessity.
Be sure to contribute enough to your 401(k) plan to get the maximum match from your employer. In addition, you should diversify your retirement accounts to avoid high taxes in the future.
