This post is from Corinne Hoener. Corinne is a long-time GRS reader and personal finance geek living in Brooklyn, NY with her partner and two cats. Some reader stories contain general advice; others are examples of how a GRS reader achieved financial success or failure. These stories feature folks with all levels of financial maturity and income.
I'm starting a new job soon (very excited!) and I'm fortunate enough to be receiving a raise in salary. Whenever our household income changes, I like to crunch some numbers to determine if our savings rate or allocations need to change. We're currently saving for a lot of things. Our biggest goal is to be saving between 20-25% of our gross income for retirement. We're also contributing to a 529 for my partner's graduate education and we're saving for a home down payment.
With my bump in salary, I have the potential to max out my 401k. This is new for me and I feel very privileged and grateful to be in this position. However, the thought seemed a little daunting – $17,500 is a LOT of money to be putting in one place. We have so many things we want to save for. Maybe it would be wiser to contribute less to the 401k so we'd have more money available for other things?
This morning I crunched the numbers and I've very glad I did because I found a clear answer to this question – MAX IT OUT.
I ran two scenarios – one in which I contributed just shy of the maximum allowable amount and one in which I contributed about 3 percentage points less.
In the first scenario, I contributed $16,200 to the 401k (with employer match it comes very close to the max), paid $23,616 in taxes annually and received a take-home paycheck of $1,930 biweekly.
In the second scenario, I contributed $13,500 to the 401k, paid $24,480 in taxes annually and received a take-home paycheck of $2,001 biweekly.
|Scenario #1||Scenario #2||Scenario #2 – Scenario #1|
|401k Contribution||16,200||13,500||– $2,700|
|Annual Taxes||23,616||24,480||+ $864|
|Annual Net Pay||50,184||52,020||+ $1,836|
|Biweeky Net Pay||1,930||2,001||+ $70|
As you can see, in scenario #2, I'm contributing $2,700 LESS to the 401k, but only bringing home $1,836 more annually. That's because in scenario #2 I'm paying $864 MORE in taxes. Yikes.
This should be obvious to anyone familiar with retirement accounts and their tax benefits. But what really surprised me is that a 3 percentage point increase in my 401k contributions, which, intuitively, I assumed would have a big impact on my take home pay, only results in a loss of $70 per check. From my perspective, I would be a fool to cut back my contributions by 3% just to gain an extra 70 bucks with each check. However, someone else might feel differently about this. For instance, if you're paying off high-interest debt, an extra available $70 every two weeks might be far more valuable to you for that debt payment.
The bottom line is that number-crunching is really important. If I hadn't done this exercise, I probably would have just contributed less to the 401k because my intuition was that it could really help us achieve our other goals. But at the price of $864 more in taxes every year, it clearly doesn't. But I never would have known this if I hadn't whipped out the calculator.