You probably know that contributing to a 401(k) plan is the right thing for your future, but how do you know how much is enough?
The right contribution level depends on your situation. Tools such as online calculators can help you calculate the right percentage for you. Alternatively, there are some benchmarks you can use to get a feel with how your contribution levels fit in with the community of 401(k) participants.
The mathematical approach
The variables involved in working out a 401(k) contribution percentage include:
- Prevailing interest rates
- Return on investments
- Years till retirement
- Savings so far
- Savings target
Fortunately, there are automated calculators that can help you process all these variables and arrive at a contribution target. Use the one on your 401(k) plan's website, or this retirement planner from CNN Money.
If you use a 401(k) calculator, make sure you use realistic assumptions about what kind of interest and growth you expect from your investments. Given the low interest rates and uncertain investment returns so far in the 21st century, certain long-term historical averages may no longer make good assumptions.
Finally, be sure to accurately account for inflation when figuring out a retirement funding target. A target you set based on today's dollars is likely to be worth significantly less by the time your retirement date rolls around.
The benchmark approach
While it's a worthwhile exercise to calculate a 401(k) contribution target based on your specific needs and circumstances, it's far from an exact science. A few simple benchmarks can help indicate whether you are on the right track.
Your first goal should be to maximize your employer match. Not all 401(k) plans do this, but in many plans the employer will match some or all of your contributions to the plan -- commonly the first 4 percent. This is completely free money to you, so you'd be losing out if you didn't take full advantage of an employer match. Whatever the employer match is for your plan, aim to get your contribution percentage at least that high as soon as you start participating in the plan.
Beyond that initial threshold, employee contribution levels tend to increase with age. According to the Employee Benefit Research Institute, here are median contribution percentages by age group:
- Under 35: 4.2 percent
- 35 to 44: 5.2 percent
- 45 and above: 5.7 percent
Most Americans are woefully behind on their retirement savings, so these averages should not be considered worthy goals, but minimum thresholds you should beat. Instead, here are some healthier goals to shoot for:
- In your 20s, start by maximizing the employer match, and then try to build up to 10 percent by age 30.
- In your 30s, try to build from 10 percent to 15 percent.
- Once you reach age 40, shoot for the maximum contribution allowed by the IRS. This was $16,500 for most participants in 2010, and will be adjusted to the cost of living in subsequent years.
In short, the best way to fund retirement is to keep trying to contribute a bigger percentage to your 401(k) plan than you did last year, until you reach the allowable maximum.
How much are you contributing to your 401(k) plan? How did you arrive at this decision?