How Much Should You Contribute to Your 401(k)?

When it comes to figuring out how much you should contribute to your 401(k), the best answer is usually how much you can afford. But that amount can vary based on your age and current financial situation, as well as your 401(k) annual contribution limit.

Here’s what to consider when determining how much to contribute to your 401(k).

3 Key Factors Affecting Your 401(k) Contribution

If you ask a financial advisor how much you should contribute to your 401(k), many will recommend deferring 10 to 15 percent of your salary. But the percentage that’s right for you depends on three factors:

Your age: The earlier you start contributing, the better, because of the compounding effect of money. The fewer years you have between now and when you plan to start drawing on your 401(k) in retirement, the higher the percentage of your salary you’ll have to contribute during the years you remain in the workforce.
How much can you afford to contribute: This consideration is especially important if you have fixed payments to make such as student loans, car loans, a mortgage or rent, child or dog daycare, or perhaps even medical bills. You will need to be able to set aside money after your necessary expenses.
Your retirement goals: You need to think about what type of retirement you want. It’s important to have a realistic retirement goal and this can impact your contribution decision. Maintaining your current standard of living after retirement requires about 80% of your pre-retirement income. If you want a more comfortable retirement, you’ll need to save more.

How Much Can You Contribute to a 401(k)?

The IRS imposes contribution limits on 401(k)s: For 2024, the contribution limit is $23,000, with an additional $7,500 allowed in catch-up contributions for workers age 50 or older.

The date you can join your employer’s 401(k) plan depends on how the plan was set up. Some plans allow employees to join on their first day of work, but other plans may require a waiting period of up to a year. If your employer’s plan has a waiting period, consider setting up an IRA so you can start saving for retirement right away.

Matching employer contributions

If your employer matches your contributions, you should try to contribute at least as much as the company’s matching contribution, since this is effectively “free money.” For employees who work at organizations that match 401(k) contributions, the IRS limits mentioned above do not include employer contributions.

The most common contribution formula is 50 cents for every dollar saved, up to 6% of salary. So, if an employee contributes 6% and the employer contributes 3%, the employee is actually saving a total of 9% per year. Some employers offer an even larger contribution.

If your employer doesn’t offer a matching contribution, some employees have found it wise to first contribute the maximum to an IRA and then start contributing only to their company’s 401(k).

Pay your taxes now or later when you contribute to your 401(k)

When you enroll in your employer’s 401(k), you’ll need to decide whether your contributions will be pre-tax or after-tax—that is, whether they’ll go into a traditional 401(k) or a Roth 401(k), if your employer offers a Roth option.

By saving before tax, you defer the tax on your contributions until retirement. For example, a worker aged 50 and over, in the 12% tax bracket (married couple filing jointly) with taxable income of $80,000 who defers the maximum for 2024, or $30,500, will reduce their tax by $3,660.

By saving for after-tax retirement in a Roth 401(k), you pay taxes on your contributions now at your current tax rate. When you access the money after age 59 1/2, withdrawals will be tax-free as long as the funds have remained in the account for at least five tax years.

If your employer’s plan allows it, you can take advantage of both types of contributions to diversify your tax situation in retirement.

When determining your contribution percentage, consider automatic increases

In 2022, the average employee contribution to a Vanguard 401(k) plan was 7.3% of their salary, according to Vanguard’s How America Saves report. Meanwhile, only 22% of 401(k) plan participants saved more than 10% of their salary for retirement.

If you can’t afford to contribute much initially, many employers will let you automatically increase your contribution percentage each year (up to a maximum of 10%), which can be a more comfortable and gradual way to increase your contribution amount.

A 401(k) plan can be one of your best tools for building a secure retirement. But you may also want to consider other retirement investment alternatives.

In conclusion

Contributing to a 401(k) account can be one of the best investments you can make for your future. Even if you can’t contribute the maximum amount, starting as early as possible and contributing regularly throughout your career will ensure you have a smooth retirement.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. Furthermore, investors are advised that past performance of investment products is no guarantee of future price appreciation.