How Much You Should Contribute to Your 401k

Sep 16

How you save for retirement is truly one of the most important financial decisions you’ll ever make in your lifetime. Whether your golden years are 10, 20, or 30+ years out, the right strategy can make all the difference.

If you're fortunate enough to have access to a 401(k) plan through your employer, you can rely on this powerful tool to help build your retirement nest egg. However, given so many evolving rules and regs, it can often feel overwhelming to learn what's involved and how to get the most out of your plan.

This article is here to help: breaking down how much you should contribute to set yourself up for a comfortable and enjoyable retirement. Let's get started!

401(k) fundamentals: what you need to know

A 401(k)—a retirement savings plan offered by employers wherein both parties potentially pay into the account—is a convenient way to save because contributions are automatically deducted from your paycheck. No manual intervention is required!

Let's break down the fundamentals of a 401(k) plan so you can make the most of this retirement savings tool.

Employer match

Employers will often match a specific percentage of employee contributions up to a certain limit. For example, for every $1 you invest, your employer might contribute $0.50 up to 5% of your total salary. This is a huge advantage as quite literally an automatic pay increase or "free" money you can access later.

Tax advantages

If the employer match scheme isn’t enough incentive, 401(k) plans also come pre-loaded with tax benefits. Two different approaches exist here:

• Traditional 401(k): With a traditional 401(k) plan, contributions are drawn from your pre-tax income (in other words, before your income tax is calculated). The corresponding benefit? You lower your taxable income in the year you contribute, ultimately paying less tax that year as the money is instead taxed when you withdraw it during retirement.

• Roth 401(k): Roth 401(k) plan contributions, meanwhile, come from after-tax income. The benefit here is that investments grow tax-free, and you won't pay any taxes on withdrawals during retirement.

Investment choices

It's your money; you should have a say in how it’s managed! This is one major benefit of a 401(k) plan, as employees who participate typically enjoy access to a wide variety of fund options. In most cases, these take shape as mutual funds that bundle different stocks, bonds, or other assets together. Diversification is thus built in, minimizing risk.

Moreover, funds are managed by professionals who cater to your own personal risk tolerance and time horizon. As a general rule, the longer your time horizon, the greater your risk tolerance—but a one-size-fits-all approach of course doesn’t exist. Your income, employment details, and short- and long-term goals all influence how much you should invest (and in what).

What is your ideal 401(k) contribution?

There's no “magic number” out there, but definitely consider these factors when deciding what to contribute:

• Are you maximizing your potential employer match? Prioritize getting the full match, which ultimately reflects a portion of your total compensation. Missing out means leaving money on the table!

• When exactly do you plan to retire? The earlier you begin saving, the less aggressively you need to save thanks to compound interest. Those who start later may require higher contributions to catch up.

• How do you envision retirement? What type of lifestyle do you want? Consider your income needs, potential Social Security benefits, and other investments when answering this question.

• Are your finances balanced? Maintain emergency savings, pay off high-interest debt, and manage current expenses while pursuing your retirement goals.

Not sure where to start? Consider these benchmarks:

• The 10% starting line: This is a manageable goal for many. If it's tough, however, start smaller and increase your contributions gradually (even by 1% each year).

• Aim for 15% (or more): This level can set you up particularly well, especially if you contribute early and often. The power of time is on your side!

• 50+ catch-up: The IRS allows additional contributions if you're aged 50+ as a great way to boost savings if you started on the later side.

2024 401(k) contribution limits

Keep these contribution limits in mind:

• 2024: $23,000 ($30,500 for those age 50+)

Note that employer contributions don't count toward these numbers.

What to do if you overcontribute to your 401(k)

Any amount you contribute above IRS limits is considered an "excess contribution."

Whether you intentionally or accidentally over-contribute, you’ll need to remove these funds from your account or otherwise face a 10% early withdrawal fee on the excess amount. These funds are also considered income, meaning excess contributions are taxed twice—once in the year you contribute them and again when you withdraw them.

Contact your employer or plan administrator immediately to correct an overcontribution as you’ll need to fix the error before filing your income taxes; he or she will then return the excess funds to you (including any additional earnings)—an action known as a “corrective distribution”—and issue an amended W-2.

Note your returned excess contribution will be added to your total taxable wages (hence the amended W-2), and you’ll need to pay taxes on any income earned from the same—receiving a 1099-R form to do so.

Retirement savings options beyond your 401(k)

While your 401(k) is a fantastic foundation for retirement savings, maximizing your options can lead to an even more comfortable future. This is precisely where IRAs come into play.

An IRA (individual retirement account) is an account that helps you grow your retirement money. You have two options in this respect: a traditional IRA or Roth IRA.

• Unlike a 401(k), anyone with earned income can open a traditional IRA regardless of employer-sponsored plan access. Contributions may be tax-deductible, potentially reducing your taxable income, but income limits and other factors can affect eligibility.

• Roth IRA contributions are made with after-tax dollars, so while you won't enjoy an immediate tax break, qualified withdrawals are entirely tax-free in retirement (including all returns your investments have earned over the years). The primary drawback here is that your ability to contribute is phased out at higher income levels. In 2024, the phase-out range for single tax filers is between $146,000 and $161,000 ($230,000 to $240,000 for those married and filing jointly); those whose income exceeds the maximum threshold aren’t eligible to contribute to a Roth IRA (but can instead opt for a backdoor Roth IRA strategy).

Which IRA is right for you?

The best choice ultimately depends on your own individual circumstances, so you’ll want to consider your current income, expected income during retirement, and overall tax strategy when deciding which IRA to forge forward with.

How to get the most out of your retirement savings

The moves you make today have big consequences in the future. With this in mind, you can enlist the help of these smart savings strategies to maximize your savings and reach your goals more quickly:

• Automate your savings: Set it and forget it! Automatic contributions straight from your paycheck ensure consistent savings and remove the mental burden. Your future self will thank you!

• Boost your contributions: Can you raise your contribution by 1% or more with each pay raise or bonus? While this small bump may feel insignificant in the short term, the additional money really does add up over decades due to the power of compound growth.

• Listen to the experts: As every situation is unique, a financial advisor will assemble a holistic plan that considers your own personal retirement timeline, other investments, risk tolerance, and tax strategy for optimal returns.

• Take full advantage of catch-up contributions: When you become eligible for higher contribution limits at age 50, you can use these to compensate for lost time or build a larger nest egg if you can.

• Regularly review and adjust: As your financial needs and challenges will change over time, review your savings rate and asset allocation on a periodic basis to ensure your retirement plan always aligns with your lifestyle goals.

Let time do the heavy lifting

The right 401(k) contribution amount is unique to you. Maximize employer match, contribute as much as you can manage, and start now. Compounding works wonders over time—Einstein called it the “Eighth Wonder of the World,” after all!

Seeking personalized guidance on your retirement savings plan? Don't hesitate to schedule a no-obligation appointment with one of our financial advisors today.