How Much Should You Contribute to Your 401k?

This year marks another increase in the contribution limit to the sometimes controversial, but “everyone’s got to have one” 401k.

In 2017, the pre-tax contribution ceiling was raised from $18,000 to $18,500. That figure gets bumped again to $19,000 on January 1st, 2019. At the outset of your career, it’s crucial to answer the question…

How Much Should You Contribute to Your 401k? Read On!

In the Cubert household, we contribute only 6% of the author’s pre-tax income to the 401k. The reasons are twofold:

1.) My company matches dollar for dollar up to 3%, and then 50 cents on the dollar for the next 3%. So it’s free money I’d be leaving on the table from zero to 6%!

2.) Diversification is a mighty sword in any portfolio. I stop at 6% and put the rest into real estate and debt paydown.

A few small breaks aside, I’ve always contributed to my 401k. Since I got my first job out of college making $27,500 per year, the 401k has been a constant companion. Over the years I’ve contributed anywhere from 8% to 15% to 0% and most recently, 6% of my gross pay.

My wife doesn’t have a 401k and never has had one. Her small business profits have helped us with student loans and mortgage debt payoff. At some point, we could explore the “solo 401k” for her, but it may not make sense to go that route, based on what we’ve accumulated with my ever-growing worker-bee plan, going strong now 22 years into its snowball.

What Is a 401k?

There’s some mildly interesting history about the 401k and its origins found on good old Wikipedia:

In the early 1970s, a group of high-earning individuals from Kodak approached Congress to allow a part of their salary to be invested in the stock market and thus be exempt from income taxes. This resulted in section 401k being inserted in the then taxation regulations that allowed this to be done.

The section of the Internal Revenue Code that made such 401k plans possible was enacted into law in 1978. It was intended to allow taxpayers a break on taxes on deferred income. In 1980, a benefits consultant and attorney named Ted Benna took note of the previously obscure provision and figured out that it could be used to create a simple, tax-advantaged way to save for retirement.

The client for whom he was working at the time chose not to create a 401k plan. (Benna) later went on to install the first 401k plan at his employer, the Johnson Companies (today doing business as Johnson Kendall & Johnson). At the time, employees could contribute 25% of their salary, up to $30,000 per year, to their employer’s 401k plan.

Fascinating stuff… Thank goodness some kind-hearted fellows from Kodak came along like the four horsemen of the apocalypse, to slay our future pensions (despite some positive tax-avoidance intent!) At any rate, we now have 401k plans to keep us entertained and mystified.

There’s a significant benefit tandem with 401k’s: First and foremost, any amount an employee contributes gets knocked off his or her taxable income (except social security and Medicare). Rejoice! This is quite nice when you creep up on higher earnings brackets.

The second big-daddy benefit is that capital gains taxes are avoided, throughout your earning years. Of course, you will pay ordinary income tax on 401k withdrawals after retirement. It’s like having a job again, without work! Haha…

Oh, in case you didn’t know already, the earliest one can start to withdraw without penalty is age 59.5. But by then, you should be looking at a much lower tax bracket, since you’ve been so disciplined at reducing expenses and paying off debts, like the mortgage (i.e., You don’t need to withdraw as much from your 401k, because you don’t have as many obligations, hence fewer taxes…)

Examples of 401k Savings Rates Over Time

Now that we’re salivating over those tax-advantaged benefits, coupled with the fact that the market only ever goes up*, I’m sure a few readers are ready to pull the trigger on maxing out that new $19,000 individual annual limit. Forget about groceries and the heating bills. We need to save, save, save!

First off, let’s make a big, fat Suze Orman-like assumption that you’ll want to have a tidy sum of $2M saved up from your 20s to age 60. Why $2M? You may need a good chunk of that coin for health care in your advanced years.

Fidelity says the average couple will need $280,000 to cover healthcare costs. That’s roughly $10,000 per year until age 90ish, when we assume (hopefully!) we’ll punch our ticket.

Beyond this, there’s a growing market for advanced medical technology and age-defying therapies that you might want to check into. Talk about the “haves” and the “have nots”! We’re seeing an ever-increasing separation of wealth that imparts significant purchasing power for a few over the many.

Need to stave off cancer with advanced gene therapy, or control a disease with an exotic cocktail of pharmaceuticals? That stuff takes lots of money, and insurance plans aren’t always keen on paying. But I digress…

For now, we’ll keep this exercise somewhat pedestrian. $2M is a middle-class target that a hard-working couple can achieve if both contribute somewhat consistently (and wisely) into their 401k accounts.

And who wouldn’t want to have $100,000 per year (or more) to work with at age 60, to travel, pay for meds, support worthy causes, and help family in need?

The example in the exhibit above closely reflects the pattern in the Cubert household. For some time when the kids were born, THIS GUY opted not to put a cent into his 401k for almost two years. Oh yeah, and there was the entire year of being laid off back in 2002.

The problem with that? I was leaving free money on the table. Those three years of not contributing likely have cost us around $100,000 when it’s all said and done. But I can’t be too hard on myself. Because for two of those three years, our extra dollars were being pumped into high-yielding real estate investments.

This exhibit lays out what happens if you contribute small amounts early in your career. Our hypothetical couple isn’t even contributing more than 6% of their gross pay until age 40. Man.

Just imagine if they were Kung Fu financial millennials right out of the gates, saving 10% or more in their early twenties. They’d have another half a million dollars at their disposal by age 60. “Hai yah!”

Overall, it’s a pretty magical scenario. What makes it work is the employer match. That free money can’t be ignored. Some companies offer more than 100% for the first 3%, and some offer less. Take a good look at your company’s retirement plan benefits.

You’ll want to consider matching dollars as a key part of your total compensation package. For instance, I’d take a $55,000 annual salary with a 100% 401k match up to 6% of gross pay, over a $60,000 salary with no 401k savings plan benefit.

401k Contributions With a Modest Income

The example above suggests you should save at least 5% to 20% of your gross income in a 401k plan, scaling up as your pay increases throughout your career. The assumption is you have two income earners making solid pay and making solid strides in pay increases as the decades roll on.

But what if you’re a couple where one partner works part-time? What if the economy takes a huge long-term dump on local manufacturing, and you lose your job and are unable to relocate?

The example above assumes a combined income that never exceeds $60,000 gross pay. This family will be hard-pressed to make ends meet and find decent, affordable housing. There won’t be any fancy vacations to Disney World or the Mall of America. Take this example with a grain of salt, because there’s a lot that isn’t factored into the narrative.

One thing that’ll pop out is how the power of compounding can work some real magic, given time. Even in the leanest years, where no dollars are contributed to a 401k, this household’s retirement savings doubled. That’s simply by letting the market do its thing, while your dividends get reinvested during a period of exceptionally strong economic growth.

In this example, the advice is to squirrel away 15% of your gross pay right out of the gates, if at all possible. (If your employer doesn’t offer a 401k, go to Vanguard to get an IRA set up, in addition to a taxable investment account.)

When I was making $27,500 per year living as a bachelor in my 20s, I only socked away 8% or $2,200 annually. Why? Well, I had to pay off my student loans of course (oh, and I wanted to buy a new car…)

If I’d nearly doubled my 401k savings to 15% or $4,125 per year, that extra $2,000 pre-tax would’ve meant about $1,500 less money in my pocket, year over year, or $125 per month. A smarter version of me in my 20s would have avoided the new car payment and chosen a reliable used car instead, as a trade-off to maxing out my 401k.

But what can I say? That Saturn had sweet pop-up heads-lamps, before they rusted shut…

Is $1 Million Enough to Get You From 60 to 95?

The reassuring answer is most likely… Assuming you keep your nest egg in a mixed equity and bond fund (an Admiral fund from Vanguard, like VTSAX — now available with $3,000 minimum) from age 60 onward, you can expect a decent return of 5% year over year. You can take out a healthy chunk each year, knowing that you don’t want to be sitting on millions of dollars at age 95.

For the first exhibit where we grew our retirement stash to $2 million, you can afford annual living expenses of $100,000 and then starting at age 80, $150,000. Not bad. And bonus, you’ll still have about $360K stashed at age 95.

For the second exhibit at $1 million in 401k savings, you can afford a lifestyle of $50,000 per year, and then $80,000 per year starting at age 80. I ramped up the annual spending in both scenarios, assuming increased medical expenses and care arrangements. Our lower-income household would have about $340K in the stash by age 95.

The catch? Those are today’s dollars. It’s difficult to predict how much more expensive the future will be but rest assured, inflation is a steady train that eats up 2-3% in purchasing power, year over year. We may be able to rely on social security to offset some of this, but nothing can replace the power of saving as much as you can, as EARLY as you can.

I’m not going to convince you to save 50% of your income, because that’s not realistic when you’re starting and facing student loan payments, all while trying to build a life. But make saving the max a stretch goal; something you work your way up to, over time.

Coming to Terms With 401k Risks

Did you catch that little splat in the previous section, did you? Good. Cuz the truth of the matter is that the market is not something anyone can predict. It’s a bit safer than a weekend in Vegas.

Historically, the U.S. equity markets have steadily risen over several decades. (Whereas the blackjack table leaves you in tears…) The market has shown some serious resilience, despite several big dips during recessions and one whopper of a depression.

U.S. Stock Market Growth – A 100-Year History

The “dark side” is that you could be happily squirreling away your pre-tax dollars for, say, 10, 20, 30, or 40 years. Then, all of a sudden, a crash like the 2008 financial crisis comes along, and poof! Your 401k balance gets halved. What the beef, man?!?

But again, resilience. Given time, the market recovers to its pre-crash levels and begins to grow again. The trouble is when folks get super close to early retirement, and a crash spooks them into staying put in their cubicles.

I’ve seen this before. A 65-year-old colleague hung up his spurs in late 2008, only to return as a contractor the next spring because he was spooked about his retirement funds.

And who knows? He or his wife may have had some underlying health concerns and simply couldn’t afford to rely solely on Medicare. I can imagine how frightening losing 50% (or more) of your nest egg in one fell swoop would be.

401k Administrative Fees: The Ultimate Parasite

Then there’s this lovely side of 401k’s: The administrative fees from Hell. These are the so-called costs to maintain and deliver a 401k plan to John Q. Worker Bee.

It’s a revenue-generating cut of your savings that your employer ponies up to its 401k plan provider. In general, if you work for a large company (10,000 plus employees), your odds of lower administrative fees are decent (hovering on average around 0.25%).

Contrast that with small employers of 100 or less, where the fees could range as high as 0.75% to 1.0% (or more!) That’s simply because the smaller the company, the less bargaining power they have with a fund provider like a Fidelity or Schwab.

Do your homework, and figure out how much of your 401k kitty is getting skimmed for those fees. A 1.0% chop off the top can gouge you for over half a million dollars throughout a career.

What else can you do? Besides finding an employer with a better plan, be sure to study each of the funds available to you within the 401k. In most cases, you will find a fund that simply tracks the total stock market, or S&P 500.

Because these so-called “index funds” are just following what the market does, the administrative “lift” is minimal, so the fees should be minimal too. I put all of my 6% into a Vanguard large-cap fund that has admin fees of less than one-quarter of one percent.

Make Your 20s COUNT

Now that you have an idea of how much to set aside in your 401k, there are a few other tips that can help you reach your goals faster:

1. Avoid taking out 401k loans. If it’s an emergency, sure. But taking out a loan on your retirement plan is costly. The longer those dollars are NOT in the kitty because you pulled them for a kitchen remodel, the longer they’re not growing in a tax-shielded snowball. Stick with home equity lines of credit, if you have the option. I have taken out a 401k loan for a real estate purchase. I paid it off within the year, and luckily, it was the year the market tanked by 37%.
2. Diversify. Don’t rely solely on your 401k. Look into real estate. Explore cash-flowing side businesses. We could have a much larger 401k without our real estate properties, but the rentals have terrific yield and tax benefits that take a lot of the pain away when market corrections occur. I would also argue you could count on social security to be there in another 30-50 years, but plan as if it won’t be.
3. Max out your 401k if your lifestyle can afford it. You won’t regret it later when a massive nest egg piles up. Besides, you’ll be surprised how much you can save in taxes, which helps take the sting out of squirreling away $19K per year (per earner). But take heed, high-income maximizers: Many employer benefit plans do not go out of their way to true up your contributions throughout the year. If you max out your $19K earlier in the year, you may not get the full employer matching dollars. Spread out your contributions, and examine your paychecks throughout the year to avoid losing some of that free money!

Finally, remember that simple time and consistency in contributions will make all the difference. Even if you aren’t maxing out your 401k, an impressive stash of retirement dollars is bound to accumulate. This year alone, 168,000 Americans had 401k’s that surged past the $1M mark, a jump of 41%. It’s a club that’s FAR from exclusive.