The 401(k) is the primary tool used to save for retirement today. It can be hard to determine how much to contribute to your 401(k) when you factor in debt, savings, and other financial goals. This article explores how to balance the 401(k) contributions with other financial priorities to help you answer the question, how much should I contribute to my 401(k)?
The Easy Answer
While there is no clear cookie-cutter answer to how much you should contribute to your 401(k), the easy answer is: ALWAYS contribute up to your employer’s match. If you forego contributing up to the match, you’re basically leaving free money on the table. If your employer doesn’t offer a match, we’ll explore other options later on. For example, let’s say your employer offers a 100% match up to 5%. If your salary is $70,000 a year, they will match dollar for dollar, up to $3,500 (5% of $70,000) in contributions to your 401(k). When you look at it in dollar terms, it becomes much harder to leave this money on the table. ALWAYS contribute to your employer’s match!
The Hard Answer
While it’s a no-brainer to make contributions up to your employer’s match, it’s much harder to determine how much more to contribute. There’s a balancing act between making 401(k) contributions, paying off debt, and establishing emergency savings. Not to mention potentially saving for a home, a child’s college, etc. The list of financial priorities goes on and on.
You often hear certain percentages thrown around in regards to savings. Typically, they range from 20-30% of gross income should be set aside for long-term savings/investments. Obviously, not everyone is able to meet these percentages, however, we do believe they are good targets to strive for. Increasing contributions to a 401(k) or savings every year by even 1% can drastically improve your chances of building wealth over the long term. The following financial priorities should be considered in conjunction with contributing to your 401(k).
If you don’t have an emergency savings account set up for roughly 3-6 months of living expenses, it’s a priority you’ll want to tackle first. Start setting aside a weekly/monthly contribution to a savings account until you have enough to cover 3-6 months of living expenses depending on what you feel comfortable with. There’s nothing worse than having to scramble for cash should something unexpected and costly occur.
Credit cards and student loans are two examples of high-interest debt that can negatively impact your financial situation. Compound interest works against the borrower and is especially deadly when interest rates are high. If ignored, the amount owed over time continues to increase at a compounded rate. Therefore, paying off high-interest debt should be a priority alongside hitting your employer’s 401(k) match.
After you’ve established emergency savings and set up monthly payments that eat into the principal balance of your high-interest debt, you should consider increasing your 401(k) contributions. The max amount you may contribute in 2022 is $20,500. Over time, if you’re increasing your annual contributions by 1-2% each year, you’ll surprisingly hit that number pretty quickly.
Individual Retirement Account
Another option you have to increase retirement savings is through opening an IRA. You may choose to do this before increasing your 401(k) contributions. The benefit of an IRA is you aren’t limited to the investment selection provided by a 401(k). An IRA has the flexibility to invest in any number of stocks, bonds, funds, or ETFs. The fees associated with investing are also potentially lower in an IRA.
Lastly, the IRA’s close relative, the Roth IRA, could be even more attractive. The Roth IRA is after-tax contributions that grow tax-free. Meaning you are taxed today on the contribution but in the future when you withdraw the money it’s tax-free. Another benefit is any contributions to a Roth IRA can be withdrawn without penalty or tax. In the unfortunate event you absolutely needed cash, the Roth contributions would be available.
The Bottom Line
Again, there isn’t a cookie-cutter answer to how much you should be contributing to your 401(k). A good benchmark to shoot for however is 20-30% of your gross income going towards long-term savings/investments. Once you’ve tackled funding an emergency fund, and automated paying off high-interest debt, you should feel comfortable with increasing your retirement contributions. Whether that’s in your employer’s 401(k), IRA, or Roth IRA, the more you put away today, the better off you’ll be in the future.
For a personalized recommendation to help you answer “how much should I contribute to my 401(k)”, schedule a free consultation today.