How much money will you need to shore up a comfortable retirement? Here are three strategies that may help you optimize your 401(k) plan in the year ahead.
Life expectancy continues to expand, thanks to new advances in medical care and a focus on better health habits. A longer life often means more years in retirement, which could last 30 years or more.
How much money will you need socked away to shore up a comfortable retirement? The IRS suggests you’ll need up to 80% of your annual income today to help ensure your quality of life continues once you say goodbye to a regular paycheck. And when you consider the average benefit amount paid monthly by the Social Security Administration is $1,177, it becomes clear that many of us need to boost our nest egg.1
One of the simplest and most effective ways to save for retirement is to contribute to your company’s 401(k) plan. A 401(k) plan allows you to defer a portion of your paycheck to your retirement account each pay period automatically, while potentially reducing your tax bill this year. But are you getting the most out of your 401(k)?
Here are three strategies that will help optimize your plan in the year ahead:
Does your employer offer a matching contribution to your 401(k) plan? If so, find out how much you need to save to qualify for that match. The most common match formula is 50 cents for every dollar saved, up to 6% of your pay. Employees in this type of plan need to contribute at least 6% of their salary to the 401(k) plan to get the maximum possible 401(k) match.
Saving 6% of your pay in a 401(k) plan and earning a 3 percent match means you are tucking away an amount equal to 9 percent of your salary each pay period for retirement. For a worker earning $75,000 per year, this means an annual 401(k) contribution of $4,500, plus another $2,250 in employer contributions. This match is a powerful incentive—essentially “free” money from your company—that will help you get closer to your retirement savings goal.
If your employer does not currently offer a matching contribution, it still makes sense to contribute to your plan on a regular basis for three important reasons:
1. You get a tax break. Your contributions don’t count toward your gross income for the year, lowering your taxable income.
2. Your money potentially grows tax-deferred. If you had earnings in a savings account or brokerage account, you would have to pay taxes on the earned interest or dividends at the end of the year. With a 401(k) plan, your earnings are rolled back into the plan and are not listed as income on your tax return until you withdraw them. As a result, your account balance has the potential to grow faster.
3. Your interest compounds. This is what makes a 401(k) plan so powerful. Any earnings you receive are reinvested, so you earn interest on your original principal plus interest on the earnings. Over the short term, the gains may appear small. But over time, you can experience larger results.
Taking advantage of a company match helps you capture valuable contributions from your employer, but it may not be enough. Most 401(k) providers recommend saving 12% to 15% annually over the course of your career.2 But, the average 401(k) contribution was 6.8% annually in 2017, according to Vanguard 401(k) plan data.3 And only 20% of 401(k) participants saved more than 10% of their salary for retirement.4
One way to save more is to challenge yourself to beat the average savings rate and account balance for people your age. Look at the numbers below and see how you compare. If you aren’t measuring up, now may be the time to increase your deferral rate.
Under age 25
Average 401(k) account balance: $4,773
Average 401(k) savings rate: 4.8 percent
Age 25 to 34
Average 401(k) account balance: $24,728
Average 401(k) savings rate: 5.9 percent
Age 35 to 44
Average 401(k) account balance: $68,935
Average 401(k) savings rate: 6.3 percent
Age 45 to 54
Average 401(k) account balance: $129,051
Average 401(k) savings rate: 7 percent
Age 55 to 64
Average 401(k) account balance: $190,505
Average 401(k) savings rate: 8.3 percent
Age 65 plus
Average 401(k) account balance: $209,984
Average 401(k) savings rate: 9 percent
If you aren’t able to save 10 to 15% of your pay at the beginning of your career, aim to gradually increase your deferral rate over time. One smart tactic is to boost your 401(k) deferral rate every time you get a raise or bonus. This enables you to save more without reducing your take-home pay.
Another easy way to enhance your savings rate is to increase your deferral rate by 1 percentage point every year. Some companies offer an automatic escalation feature that will periodically increase your savings rate with a simple click of a box; other companies require you to manually make this change.
A good time to review your contribution amount is at the beginning of the year when you’re looking carefully at other benefits elections, such as medical and dental insurance, since the amount you put towards these benefits will have an impact on your paycheck. Another good time to revisit your contribution amount is when you receive additional compensation, whether through a raise, promotion or bonus.
In 2019, the maximum amount you can contribute to your 401(k) plan is $19,000. If you’re 50 or older, you’re eligible to make “catch-up” contributions up to an additional $6,000—for a maximum possible 401(k) contribution of $25,000.
When you max out your 401(k) plan, you not only save more for retirement, you potentially save more money since your taxable income would be lowered. That’s because all contributions to your 401(k) plan are axed when they are withdrawn, not when they are made. (i.e., A worker in the 24% tax bracket who saves $19,000 in a 401(k) plan will reduce his tax bill by $4,560.)
To max out your 401(k) plan in 2019, you’ll first need to calculate the percentage of your pay that adds up to $19,000 (if you are age 49 or younger) or $25,000 (if you are 50 or older). For example, a 42-year old worker earning $140,000 annually would need to contribute approximately 13.5% of her salary to a 401(k) plan to max out in 2019. Make sure to adjust your deferral rate after you receive a raise or bonus to avoid exceeding the 401(k) contribution limit.
If you max out your 401(k) plan, you’ll be among an elite group of American workers, as only 13 percent of 401(k) participants maxed out in 2017.5
Whether you’re nearing retirement or just starting your career, it’s always the right time to save for the years ahead. Putting these simple strategies in place will help you accumulate more money for your retirement years, while helping to save on taxes now. As you consider these ideas, it’s important to work with your financial advisor to help ensure the strategies you put into place align with other investment decisions, so that all your assets are working together to achieve your short- and long-term goals.