What Is the Recommended Percentage of Income to Put Into a 401k?
Your company 401k plan could become your best investment when you retire. That 401k plan that your employer offers you may come with a matching contribution or any number of other perks that could help you retire comfortably. The percentage of income you contribute to your 401k is determined by a number of different factors.
The interest you earn on investments determines, in part, how much you need to save every month. A savings rate of 20 percent of your income would probably be far too little if you only earned 3 percent interest on your savings. However, it might be overkill if you’re earning 15 percent annually.
Inflation erodes the value of your savings. You must add inflation to the interest rate you hope to achieve in your 401k investment account. From 1913 to 2010, the total inflation we’ve experienced in the U.S. has been 2,194.96 percent. The average inflation rate, however, has been just 3.24 percent.
You may choose a much lower number, say 1 percent, if you think inflation would be low in the future. Or, you may choose a higher inflation number, like 6 percent, if you think inflation will be higher in the future. Whatever number you choose, you’ll need to compensate for it in your investments.
Your savings goals are another factor that drives your 401k savings rate. If you have to accumulate $1 million in 5 years and you have no savings, you’d need a high savings rate, even with a strong investment return. However, if you had 30 years to accumulate that same $1 million, the percent of your income would be lower.
Additionally, the amount of money you must contribute also depends on your income. If you make $100,000 per year, but only intend to replace 70 percent of that income, then your savings rate can be lower than if you make $70,000 and want to replace 100 percent of your working income, all other things being equal.
To get an exact dollar amount, you must define your annual income goal for retirement. Take the annual income goal and divide it by the interest rate plus the inflation rate you think is realistic or reasonable. Finally, use a financial calculator to calculate the exact dollar amount you must save each month.
This gives you an idea of the recommended percentage of your income you should contribute to your 401k plan. For employers who offer an employer matching contribution, you can deduct the employer contribution amount from your own savings needs.
This makes the job a bit easier for you. For example, if you need $50,000 in retirement, and you think inflation will be 2 percent annually, then a 7 percent total interest rate would give you 5 percent of investment gains and 2 percent to cover inflation
If you think this is realistic, then you would end up with a total of $1 million after inflation is accounted for. This $1 million is plugged into a financial calculator to determine how much you must contribute to your 401k plan. Finally, a contribution from your employer would reduce your out of pocket savings requirements by whatever your employer contributes.