How much should I contribute to my 401k?

One of the more frequent questions I get from friends is “how much should I contribute to my 401k?” While there is not 1 right answer for everyone, there are a few things everyone should consider. Also consider that 401ks are still relatively new in the investment world. They’ve only been around since about 1980, so not all that many people (maybe zero) have lived off their accounts for 30+ years. Rules may change in the future with them, but it’s important to know the rules that govern them now.

Why Contribute?

If you’re following this blog, I suspect you already know the importance of investing. 401ks can be great investment vehicles for several reasons.

  1. Contributions and growth can be tax-deferred: Say you contribute $10k of your paychecks towards your 401k this year. When you file your taxes, that $10k of income will behave as a tax deduction come tax season. Then as those contributions compound and grow over the years, you still don’t pay taxes on the increase. You only pay taxes when you withdrawal the money in retirement.
  2. High Contribution limits: For 2018, the IRS limits 401k contributions to $18,500 per calendar year. On top of that, you can still contribute $5500/year to IRAs. That’s a lot of tax savings now and during all those years before retirement withdrawals.
  3. Forced Savings: It’s a beautiful thing when money goes into your investment account before it ever hits your bank account. When money hits a checking account, many people think of it as money available to spend. 401ks protect you from spending every dime. You just “set it and forget it!

So how much should I contribute?

A simple answer I offer is “max out your 401k.” Easier said than done for most, but I think it’s a good goal for those that can afford to defer $18,500/year. If you’re not sure you can afford to max out your 401k, maybe try it for just a few paychecks. At many companies, you can adjust your contribution amount whenever you want through an online portal. If you’re not in a position to put in $700+ per paycheck, at least consider this when deciding how much to contribute: If you’re in the 22% tax bracket, every $100 you contribute to your 401k will mean only $78 less going to your bank account.

Employer Contributions

If your employer offers to match an amount or percentage to your 401k plan, ALWAYS contribute enough to get the full match. I repeat ALWAYS CONTRIBUTE ENOUGH TO GET THE FULL MATCH. This is free money!

Make sure you understand the fine print of your 401k matching plan. Many 401k matches are subject to a vesting schedule. For example, your 401k match may require you to be at the company for 1 year, then 50% of the match is vested. At year 2, all the matches become fully vested. This would mean that if you leave the company, you can take all of the match with you.

The $19,500 IRS contribution limit does not include employer contributions. If you get paid twice a month, maxing it out would mean $812/paycheck. If you make $80k and your employer matches 4%, that’d be an extra $3,200/year or $22,700 total contributions in a year.

Roth vs Traditional 401k

In 2006, Roth 401ks were born. Like a traditional 401k, contributions are made through payroll deductions. They are taxed in the same way as Roth IRAs. Pay taxes before contributions are made, and no taxes are paid on withdrawals after age 59½. If you choose to withdraw before age 59½, you can withdraw your principal without any penalty. Unlike Roth IRAs, there are no income limits for those that can contribute to Roth 401ks.

Having both Traditional and Roth 401k contribution options definitely adds more room to debate where you should put your money. Since our income is high right now, we primarily contribute to a traditional 401k. We like having reduced taxes now. However, we expect to retire before age 40, so it gives me some peace knowing I could withdraw my Roth contributions without penalties before I hit age 59½ without penalty.

When will I have enough?

First off, I don’t think anyone will get to retirement and wish they had less money, so I won’t fault someone maxing out their 401k for the rest of their working career. However, for those wishing to retire long before age 60, you’ll want to be strategic about where you’re allocating your money now.

For example, let’s say you’re 30 and hope to reach FI by age 40. You have $200k in traditional 401k/IRAs and $50k in liquid investments. Without adding another dollar, $200k would become about $2 mil by age 60, with 8% annual growth. If this was my situation, I would focus on saving my money in liquid investments (taxable brokerage or Roth accounts), so I would have money accessible from ages 40 to 60. I don’t want to retire at 40 and have to go back to work at 55, because I’m running out of money or paying steep penalties to withdraw money intended to fund my later years.

I expect my wife and I will hit $200k in retirement accounts before FI. When we do, I expect we’ll only contribute enough to 401k to get all of her employer match. There’s a chance I’d move to full $18,500 Roth 401k. We’ll see how our portfolio looks when we get a little closer to that.

What if I am self-employed?

I’m self-employed now, so I don’t have a company-sponsored 401k plan. The rules above still apply though. Being self-employed, you can contribute to either a SEP IRA or an Individual 401k. Both can have even higher contribution limits, but those will depend on how you file your taxes and how much you make. Here’s a decent article that may help you decide which account type is right for you: Solo 401k vs SEP.

Last words

If you have a strong opinion on Roth vs Traditional 401k or thresholds to live by, weigh in with a comment below or Contact Me.

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