401(K): Setting Contribution Levels

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When setting 401(k) contribution levels there are several things you should consider. The end goal of retirement savings is to put yourself in the position to build a portfolio of investments that you can spend from in retirement so that you can walk away from your job and forgo your paycheck. This is known as independent wealth – where you have the ability to rely on your own investments for income instead of a job or a pension or any outside income source. The illustration below shows that a significant level of ongoing savings over a long period of time is required to reach independent wealth:

ASSUMPTIONS:

  • Save 15% of your pre-tax income for 36 years.
  • Do as much as possible in tax-favored accounts such as Roth IRAs and 401K/Profit Sharing Plans.
  • This is based on a beginning $30,000 income, rising 4% per year. Adjust your situation, up or down, from the $30,000 example.
  • Total stock market results are estimated at 10% annually in the future.
  • With 11% returns, it would take about 34 years to achieve these results. 9% returns would take 39 years and 8% returns would take 42 years.
  • Begin spending 5% annually in retirement.
Year Income 15% Annual Savings Portfolio
1 $30,000 $4,500 $4,706
5 $35,096 $5,264 $30,811
9 $41,057 $6,158 $73,188
13 $48,031 $7,205 $131,087
17 $56,190 $8,429 $230,351
21 $65,735 $9,860 $382,210
25 $76,901 $11,536 $612,186
30 $93,562 $14,034 $1,068,283
36 $118,385 $17,758 $2,021,305
-17,758 x 5%
$100,627 $101,065

Note how it took almost over three and a half decades of diligent ongoing savings that are invested correctly in order to fully replace the lost income in retirement with a reasonable 5% portfolio spending rate. If one were to save 20% annually in this illustration there would be about 33% more in the portfolio after 36 years. With 7.5% annual savings there would be 50% less. And if the funds were invested more conservatively with a 50% equities and 50% bonds allocation you could expect about 35-40% less money left at year 36. Invest early, invest strategically focusing on equity investment for growth over long time frames, and invest on an ongoing basis to get yourself towards independent wealth!

It is understandably difficult to reach the 15% savings rate for retirement so use that as an end goal to work towards. But by all means, strive to set your contribution percentage amount at least to the employer match level. If you don’t have an employer match or you need to wait several years to “vest” the matching money (which means you must earn the matching money through tenure or you don’t begin to receive matching money for several years), still contribute at least 5% so you can begin building a balance and get used to the money leaving your paycheck and living on what is left.

You should also consider how much you are able to save outside of your retirement account. You want to have additional money saved that isn’t subject to withdraw penalties (like your 401(k) assets are) so you can have money at some point for major purchases like a down payment on a home. Setting your percentage contribution so high that you aren’t able to save money outside of your retirement accounts can lead you to not achieve your non-retirement financial goals. If you can save 5% in your 401(k) and have plenty of money left over after-taxes to spend and save in a personal investment account (that section is next), then maybe you can ratchet up your percentage past the employer match. Eventually, you will run into contribution limits which for 2021 dictate that you can’t contribute more than $19,500 per year to your 401(k) account. So, regardless of your employer match, contribute at least 5%. Then, increase this amount over time to work towards the 15% target retirement savings rate and beyond to even maximize the annual funding if you are able to.

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