Planning for a secure retirement should start as early as possible. One of the critical early choices that has a huge impact to that security happens when you get your first job and the opportunity to participate in a company sponsored retirement plan.
First, there’s the choice to participate at all. While this may mean a reduction in your actual take home pay currently, remember time is your friend when saving so participating immediately and getting used to the reduced income is a great sacrifice in the long run.
Then there’s the question of how much to save. Conventional wisdom says that if your company makes a matching contribution, you should at least start by contributing enough to take advantage of 100% of the match. After all, this is free money to you, so don’t leave any of it on the table.
While contributing enough to max out the company match is a good starting point, it is just that – a start. Too often an employee will set their initial contribution limit and neglect to change it as time passes. Keep this in mind for true retirement security - as your income grows, so too should your savings.
How big of an impact would annually increasing your retirement contribution percentage until you reach the maximum limit have? Let’s look at an example provided by Nancy Anderson in an article at Forbes; the results will speak for themselves.
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Saving a little bit more may not make a big difference in the short run, but can make an incredible difference in the long run. Consider a 35-year-old (let’s call her Jacqui) who makes $50,000 per year and saves 6% of her income into her pre-tax employer plan.
She chose 6% deferral so she could capture the company match. Hats off to her for a good financial move, but why stop there?
The maximum contribution to a 401(k) for 2016 is $18,000, and employees age 50 and over can invest an additional $6,000 in a “catch-up” provision. Jacqui is not at the max, so she has room to save more.
Let’s say she got a raise of 1.5% per year, plus the typical employer match of 50% for every $1 dollar she saved. If she kept her contributions at 6% flat, with her investments earning an average of 7%, she’d be looking at a balance of around $487,000 at age 65. It’s a good start, but probably won’t cut the mustard if she wants to provide a lifetime income from that lump sum.
Now, what if she increased her contribution by 1% per year until she hit a 15% salary deferral? An increase in savings of 1% for her salary would “cost” her $500 that year, or $42 per month.
What does that mean in terms of her paycheck? If she is in the 25% tax bracket, a $42 investment in her 401(k) would only drop her take-home pay by about $31 per month due to the tax savings.
A Roth 401(k) would drop her take-home pay by the full $42 (but the earnings could be withdrawn tax-free in retirement).
A small thing like $30 or $40 a month might not make a huge financial impact today. But what difference would it make in later years if she did that every single year?
It could make a big difference — it’s monumental.
If she increased her contribution to 7% from 6% and subsequently increased it every year by 1%, she’d have over $831,000 at age 65 instead of $487,000 — about $344,000 more.
Why not bump the contribution to 2% this year and an additional 2% each year after that?
If Jacqui increased her 401(k) contribution early in the year an additional 2% this year (figuring it would drop her take-home pay by about $62 per month – double the amount of a 1% contribution) and every year after that, she’d be looking at a balance of $888,000 at age 65 instead of $487,000 with her current 6% contribution – over $450,000 more.
So the question is: What are you waiting for?