Ask Stacy: How Much Should I Contribute to My 401(k)?

Photo (cc) by 401(K) 2013

If you’ve got a 401(k), 403(b) or other work-related retirement plan, you might have the same question this reader has …

Good morning.
I’m lost on how much to contribute to my 401(k).
This is the question my employer is asking me.
My employer will match 25% of the employee contribution up to 6% of your salary, with a max of $1,000.
My gross salary is $90,894.36
My take home pay bi-weekly $2,368.48.
I want to contribute the same amount they are matching, no more and no less.
Thank you,
Adrien

While at first blush this may seem complicated, it’s really pretty simple. Here’s all you need to know:

  1. The max your employer will contribute: In Adrien’s case, $1,000.
  2. The percentage match: In Adrien’s case, 25 percent. (Another way of looking at it: For every dollar Adrien contributes, the employer throws in 25 cents.)

We can stop there and quickly see how much Adrien will need to contribute to get the maximum match. To get the answer, we divide $1,000 by 25 percent, which gives us $4,000 — that’s what she’ll need to contribute to get the full $1,000 match from her employer.

Adrien is paid bi-weekly, meaning every two weeks, or 26 times per year. So she will need to contribute $153.85 ($4,000 divided by 26) each pay period to get every penny her employer is offering, no more and no less.

Life without limits

Adrien’s right to do what’s necessary to get the maximum match from her employer. That’s because employer contributions are free money — the greatest source of no-strings-attached dough most of us will ever see. You don’t have to be an expert in personal finance to realize when you’re offered free money, you should always take it.

Many employers are more generous than Adrien’s — like hers, they match up to 6 percent, but they don’t cap their contributions at $1,000. If Adrien’s employer didn’t have the $1,000 cap, how much could she get?

The maximum you’re allowed to contribute in 2016 to a 401(k) is $18,000. If Adrien contributed the max for 2016, her employer would contribute 25 percent of $18,000, or $4,500.

If Adrien’s over 50, however, her contribution limit is higher. Thanks to catchup provisions, workers over 50 are allowed to contribute an extra $6,000 annually. So if she’s over 50, her max contribution would be $24,000 ($18,000 + $6,000) and her employer would be putting in 25 percent of that, or $6,000.

Or would they? Keep in mind that her employer also caps their contribution at 6 percent of her salary. Six percent of $90,894.36 is $5,453.66. Since that’s less than $6,000, that’s all they’d contribute.

More free money

If I offered you an interest-free loan for an indefinite period, would you take it? If you have any sense you’d take my money, invest it, earn something on it, then repay the loan many years down the road.

If you follow that logic, then you should also want to max out your 401(k) or other tax-advantaged retirement plan. Money going into your work-related retirement plan isn’t taxed until you take it out, which means it’s like getting an interest-free loan from Uncle Sam.

If Adrien contributed $24,000 to her 401(k), her taxable salary would fall from $90,894.36 to $66,894.36. According to this tax estimating calculator, here’s how much she’d save in taxes, assuming she’s single.

2016 income taxes due on $90,894.36 = $14,895
2016 income taxes due on $66,894.36 = $8,895
Savings: $6,000

These tax savings don’t exactly represent free money, because putting money in a 401(k) or other retirement plan doesn’t eliminate taxes, it defers them. In other words, when Adrien takes this money out of her plan after she retires, she’ll pay taxes on it. But in the meantime, the $6,000 she saved in taxes is hers to use however she pleases — essentially an interest-free loan from Uncle Sam.

Here’s the bottom line

I went through a lot of tedious math in this post, so I apologize if your eyes glazed over. But here’s all you need to know. First, always contribute as much to your qualified retirement as you can, because every dollar in taxes you save by doing so is like getting an interest-free loan. Second, always, always, always contribute enough to get the maximum amount of free money your employer is offering.

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The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.

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About me

I founded Money Talks News in 1991. I’m a CPA, and over the years I’ve also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. Got some time to kill? You can learn more about me here.

Got more money questions? Browse lots more Ask Stacy answers here.

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