In this article, we will discuss the amount of money you should set aside for retirement. We’ll start by explaining the rules of investing in a 401(k) account and how to calculate your monthly contribution. Then, we’ll address some common questions on this topic.
The Power of Compound Interest
The earlier you start saving for retirement, the less you will need to save each month. We can thank compound interest for that. When you earn returns on your money, those earnings accumulate at an accelerating rate.
Let’s say you want to retire at age 60 and would like to have $2 million, and you achieve an average return of 10%. This is just slightly less than what the S&P 500 has returned over the past 60 years after tax and reinvested earnings.
Here’s the amount you’ll need to invest, including your contributions and your employer’s contribution, if you have an annual salary of $50,000:
- If you start investing at age 20: You’ll need to invest $316.25 per month, or 7.6% of your salary.
- If you start investing at age 30: You’ll need to invest $884.76 per month, or 21.2% of your salary.
- If you start investing at age 40: You’ll need to invest $2,633.76 per month, or 63.2% of your salary.
The examples above illustrate not only how much money you will need to contribute to your 401(k) each month if you start saving later, but also the total amount you will need to save. In the first example, you will invest less than $152,000 in total if you start at age 20. But if you wait until age 40, you will end up investing over $632,000 to reach your goal.
You should remember that 10% is an average return, not a rate of return you should expect in your 401(k) each year. Your returns will vary based on the performance of your investments, as well as how much risk you are willing to take when choosing your investments.
As retirement approaches, you’ll want to decrease your risk, which reduces the expected annual average returns.
Rules for Investing in a 401(k)
The rules for investing in a 401(k) will not apply to everyone, but they are a good starting point for retirement planning.
Take Advantage of Employer Contribution
If you have an employer contribution in your 401(k), always take advantage of it unless you cannot pay your bills without it.
Plan to Replace About 80% of Income
When you stop working, plan to replace about 80% of the income you were earning before retirement from all combined income sources, such as 401(k) accounts, IRAs, Social Security, and pensions.
You can expect to spend less because you will no longer be paying payroll taxes or contributing to a 401(k). You may also spend less on things like fuel and clothing because you are no longer working. The actual amount you will need to replace your working income depends on how frugal or lavish you are in retirement.
The 4% Rule and 25x
According to the famous 4% rule, the risk of running out of retirement savings over 30 years decreases if you limit your withdrawals to 4% of your account balance each year in retirement. You can adjust the cash amount you withdraw each year based on inflation. Using the same rule, you will need 25 times the amount you want to withdraw annually saved by retirement time. You can adjust your contributions to your 401(k) over time based on this goal.
How to Calculate Your Monthly Contribution to Your 401(k)
In 2021, the maximum contribution to a 401(k) is $19,500 for those under 50 years old; this increases to $20,500 for 2022. Workers aged 50 and older can make an additional $6,500 contribution in both 2021 and 2022. Your contributions combined with employer contributions cannot exceed $58,000 in 2021 or $61,000 in 2022, excluding catch-up contributions.
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That said, only a few people contribute these amounts. Only 12% of participants in the plan made the maximum contribution in 2020, when the limit was $19,500, according to the 2021 Vanguard report “How Americans Save.”
To determine how much you should save, you can use the Social Security retirement calculator to find out the monthly amount you can expect from that fund. You can also use a retirement calculator to estimate how much you will need each month in addition to Social Security. Choose a calculator that allows you to customize as many factors as possible, including your current age, account balance, expected contributions, other income sources, and estimated rates of return.
Choosing Health Insurance vs. Bills vs. Your 401(k) Account
If you cannot afford your monthly bills, you cannot afford contributions to your 401(k) account. If there are unexpected expenses or a loss of income, you may even need to withdraw retirement funds early. If possible, focus on the minimum to get your employer’s match, and then use any extra money to pay off high-interest debt, like credit cards.
One option, if you’re struggling to afford your 401(k) contributions, is to choose a cheaper health insurance plan. A study by TIAA found that people who pay excess for health insurance are 23% more likely to forgo their employer’s retirement match.
A Health Savings Account (HSA) can help you lower healthcare costs and save for retirement at the same time. You can fund an HSA only if you have a high-deductible health insurance plan, which often leads to increased out-of-pocket costs. The HSA is funded with pre-tax dollars. When you spend it on qualified medical expenses according to IRS standards, your distributions for those expenses are also tax-free and penalty-free.
An HSA is a good addition to your 401(k) contributions because if you have unused funds in the account when you turn 65, you can withdraw them without penalty for any purpose, although you will owe income tax on distributions made for non-qualified medical purposes.
Frequently Asked Questions
How much should I have saved to retire early?
The general rule is to have replaced 80% of your pre-retirement income regardless of the age at which you plan to retire. Create an accurate budget for your expected total expenses annually in retirement and multiply that by the number of years you wish to spend in retirement. Suppose you plan to retire at age 40 or shortly thereafter. In that case, you need to consider things like waiting until you’re eligible for Medicare or Social Security benefits when looking at how much your expenses will be.
How much should I save in my 401(k) from each paycheck?
It is recommended to aim to put at least 15% of each paycheck into your 401(k) account as long as you can still easily afford your living expenses. It is suggested that if you cannot reach this amount, try to get to the minimum where your employer matches your investment in the 401(k) account.
Conclusion
While 15% of your pre-retirement income is a good estimate of how much you should save, the actual amount depends on your personal circumstances. The earlier you start contributing to your 401(k), the less you will need to save each month overall. Always try to contribute enough to get the full match from your employer if available. Otherwise, you are leaving free money on the table.
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Sources:
- Macrotrends. “S&P 500 Historical Annual Returns.”
- Internal Revenue Service. “IRS Announces 401(k) Limit Increases to $20,500.”
- Internal Revenue Service. “2022 Limitations Adjusted as Provided in Section 415(d), etc.,” Page 1.
- Vanguard. “How America Saves 2021,” Page 42.
- TIAA Institute. “TIAA Institute Study Finds Many Employees Overpay for Health Insurance, Limiting Their Ability to Save for Retirement.”
- Internal Revenue Service. “Publication 969 (2020), Health Savings Accounts and Other Tax-Favored Health Plans.”
Source: https://www.thebalancemoney.com/how-much-should-i-put-in-my-401k-453991
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