One of the most frequent questions that I get asked by my friends is how much they should contribute to their 401(k) for retirement. My answer is always the same– AS MUCH AS POSSIBLE. Right now as I am writing, each individual is allowed to contribute $18,000 into their 401(k) per year. This is the figure for which you should be striving.
Now let me take a step back, as I’m not so callous to believe everyone has the ability to contribute the maximum allowed in your 401(k). If you’re one of the lucky ones that actually get a 401(k) take advantage. Currently, less than 50% of Americans currently are offered a 401(k). Think about that for a second; only one out of two Americans have the ability to contribute to a 401(k). This is mind boggling!!! The average social security monthly benefit is $1,335 according to the Social Security Administration.
Albert Einstein once attributed compound interest to “the most powerful force in the universe.”
If you can’t contribute the maximum amount, I encourage you to contribute at least to your company’s match. The average 401(k) contribution company match is currently 3%. While that may seem paltry if you start at age 22, based on a 8% rate of return from the S&P 500, using the average US salary of $52,000, you can see below on chart that you can be a millionaire. For those that are curious, I also provide a column if you are able to contribute the maximum contribution to your 401(k). There is a visual chart below for those that want to see compounding interest in full effect.
|Age||3% Growth||Maximum w/ Match|
Depending on your situation, if you have debt, I would encourage you to continue to pay that down before you try to maximize your 401(k). The easy math behind this is, if you are contributing to a 401(k) that on average makes 8% a year but you pay 19% a year on a credit card balance, you would get a bigger return on your money by paying off the credit card balance. However, if you don’t have any debt except for your mortgage, I would encourage you to maximize your 401(k) as much as you can. Following the chart above, it will definitely pay off in the long run.
Now one of the newest wrinkles in the 401(k) world is the Roth 401(k). This is just like a Roth IRA with employee contributions that are not tax-deductible but will grow tax-free. Please note that the employer portion will be applied to the traditional 401(k) account. The government still wants to tax you on this amount; otherwise, it would be a no-brainer to get a match using after-tax dollars from your employer. So, now that we’ve gone through the options, which one should you do?
I contend that you should hedge just like your portfolio. I think the perfect allocation is 50% in the Roth IRA and 50% in the traditional 401(k). Unfortunately nobody knows what the future holds with taxes, so whether they go up or down, you will have a hedge of protection in the future.
If you are potentially eligible to invest in a Roth IRA, one downside to be aware of is your Modified Adjusted Gross Income (MAGI). If you exceed your MAGI, you will be ineligible to contribute to your Roth IRA. In a previous article, I went in depth with the Roth IRA, so click over there if you’d like more information.
Remember, between the Roth IRA and 401(k) you are able to contribute a total of $23,500. $18,000 would go towards your 401(k) and $5,500 towards your Roth IRA (if you are over 50, you get to save an additional $6,000 in your 401(k) and $1,000 in your Roth IRA). So, make sure contributing to a Roth 401(k) doesn’t push you over the Roth IRA limit before you contribute.
Do you contribute to a Roth 401(k) or a Traditional 401(k)? Feel free to share your thoughts below.