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.
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.1 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.2
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 may help you 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% match means you are tucking away an amount equal to 9% 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:
- There are tax advantages. In a traditional 401(k) your contributions don’t count toward your gross income for the year, lowering your taxable income. (although you have to pay taxes on the distributions).
- 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.
- Interest on your savings compounds. This is what makes a 401(k) plan so powerful. Any interest you receive is reinvested, so you earn interest on your original principal plus interest on the interest. 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. Many 401(k) providers recommend saving at least 10% annually over the course of your career.3 The average 401(k) contribution is closer to 6%.4
lf 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 2020, the maximum amount you can contribute to your 401(k) plan is $19,500. If you’re 50 or older, you’re eligible to make “catch-up” contributions up to an additional $6,500—for a maximum possible 401(k) contribution of $26,000.5
When you max out your 401(k) plan, you not only save more for retirement, you potentially pay less in taxes that year since your taxable income would be lowered. That’s because all contributions to your 401(k) plan are taxed when they are withdrawn, not when they are made. (i.e., A worker in the 24% tax bracket who contributes $19,500 in a 401(k) plan will reduce his tax bill by $4,680.
To max out your 401(k) plan in 2020, you’ll first need to calculate the percentage of your pay that adds up to $19,500 (if you are age 49 or younger) or $26,000 (if you are 50 or older). For example, a 42-year old worker earning $140,000 annually would need to contribute approximately 13.9% of her salary to a 401(k) plan to max out in 2020. Make sure to adjust your deferral rate after you receive a raise or bonus to avoid exceeding the 401(k) contribution limit.
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 reduce the taxes you pay for the current year. 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.