It’s easy to overlook the details of your 401(k) plan when you start a new job — there’s the excitement of learning the ropes, bringing in a fatter paycheck and finding the quiet bathroom.
Unfortunately, neglecting your 401(k) contributions can have a serious effect on your future. That’s because the money you invest early in your career has decades to grow, so even the most modest contributions can become an impressive nest egg with compound interest.
Even if you’re aware that you need to contribute to your 401(k), it can be tough to decide how much, especially if you have competing financial priorities. Here are eight factors to consider when deciding how much to contribute to your 401(k).
1. Know the IRS limits on 401(k) contributions
Your 401(k) plan is a tax-deferred retirement account, which means you deduct your contributions from your annual income at tax time. This also is described as funding your account with pre-tax dollars.
Since Uncle Sam won’t immediately see any taxes on the money you set aside, the IRS sets 401(k) contribution limits to prevent individuals from using their 401(k) accounts as vehicles to dodge taxes on large sums of money. In 2020, the employee contribution limit is $19,500 for participants who are under age 50.
If you are in a position to afford a $19,500 annual contribution, you should plan to send $1,625 per month ($19,500/12 = $1,625) to your 401(k) and call it day. If you’re a mere mortal with bills to pay, you’ll need to use other strategies to maximize your 401(k) contribution.
2. Take advantage of company matching
Many employers offer to match 401(k) contributions up to a certain amount. For instance, your company might offer to match 50% of your contributions up to 6%. This means that if you contribute 6% of your salary to your 401(k), your company will put in 3%, giving you 9% in total contributions.
“Your first goal should be to contribute enough to get the company match. This can be difficult if you’re just starting out, but saving has to be a little bit painful,” explained Jim Blankenship, a certified financial planner and the principal of Blankenship Financial Planning in New Berlin, Ill.
If contributing enough to reach the full company match is unaffordable, Blankenship recommended that you increase your contribution every time you get a raise or set up an automatic increase of 0.5% or 1% every six months. That will help you ease into contributing enough to get the match without feeling the bite all at once.
Another important thing to remember is that your employer’s contributions on your behalf don’t count toward your $19,500 contribution limit. Your employer may contribute as much as $37,500 to your 401(k) in 2020.
3. Contribution goals should not be static
It’s not a good idea to adopt a “set it and forget it” attitude when it comes to your contributions. “Your goals should evolve over time. Even if your initial goal is to get the full company match, you shouldn’t rest on your laurels once you get there,” warned Blankenship.
He recommended that you eventually max out the annual IRS contribution limits or put aside 20% of your annual salary — whichever is feasible. For instance, a worker earning $35,000 per year probably will not be able to afford the $19,500 401(k) contribution limit. However, setting aside $7,000 per year may be an achievable goal.
4. Make sure you understand vesting
While the company match is an excellent perk, it’s important to remember that the matching amount is not necessarily yours the moment it appears in your account. You will have to wait to be vested before you can consider that money yours in retirement.
In many cases, vesting is graduated over time. For instance, you might be vested in 20% of your company’s match after one year, 40% after two years and so on until you are 100% vested after five years of employment.
If you separate from the company prior to becoming 100% vested, then you will lose the nonvested amount. Unfortunately, this is true whether you quit, get fired or get laid off. The good news is that your own contributions are completely vested, so any money you personally put away is yours to keep no matter what happens to the company match or your employment status with the company.
5. 401(k) contributions are pre-tax
While you crunch the numbers to determine how much you can contribute to your retirement account, don’t forget that your take-home pay will not be reduced by the full amount of your contribution. Since your contribution is taken from your pre-tax salary, contributions effectively lower your annual salary, which means your tax withholding for each paycheck also will go down. So for each $100 you contribute to your 401(k), you’ll see less than $100 deducted from your take-home pay.
6. 401(k) vs. debt vs. emergency fund: how to prioritize
Most people have a number of competing financial needs, making it difficult to understand how to prioritize where your money goes. Should you build your emergency fund, focus on maxing out your 401(k) contributions or pay down debt to avoid losing money on high interest rates?
“Your top priority should be building an emergency fund of three to six months’ worth of unavoidable expenses,” said Blankenship. “Unavoidable expenses means true bare-bones minimum: rent or mortgage, car payment, utilities and groceries. You don’t need to recreate your usual monthly spending, just the amount you would need to get by.”
Once that is in place, Blankenship recommended paying the minimum amount on your debt to prioritize getting the company match on your 401(k). Credit card debt or other high-interest debt should take priority over student loan debt; however, you can work on paying down your debt while contributing to your retirement account.
7. Review the details of your 401(k) plan
How much you contribute to your employer 401(k) may depend on how good the plan is. Blankenship recommended looking at the portfolios offered by your 401(k) to determine if it’s a good low-cost investing environment for your money.
“You should educate yourself on what makes for a good diversified portfolio, and there are a number of resources online that will help you do an analysis of your potential portfolio,” he said. In particular, Blankenship recommended Yahoo Finance.
Blankenship also recommended opening an individual retirement account (IRA) if your 401(k) isn’t up to snuff. You should keep contributing to your 401(k) up to your company match; however, any contributions beyond that should go toward your IRA to take advantage of lower fees or a more diversified portfolio.
8. Determine your desired retirement age
It can be hard to think about retirement when you’re in the thick of your career, but it’s a good idea to do some basic calculations to determine how much you will need, even if retirement is decades away.
Not only will you have a better sense of what you need to set aside to reach your goals, but thinking about what you want from your future makes those goals feel more immediate (which also makes it easier and more satisfying to save money).
The precise amount to send to your 401(k) will depend on a number of factors. Meeting your company match and creating savings goals that evolve over time will help ensure you have a robust retirement account when you need it.