Nearly half of Americans plan to rely on their 401(k) or a similar retirement plan as a primary source of income after retirement. If you're in this group, there's a good chance your current contributions won't produce a sufficiently large account to provide the type of retirement you want. Here's why you might face a shortfall, and how much of a difference a small increase could make over the long run.
The most common 401(k) contribution amount, and the problem with it
Most 401(k) plans have some type of employer matching program, in which the employer matches a percentage of the employees' contributions up to a certain maximum. The majority of 401(k) participants contribute enough to take advantage of the full match.
Taking advantage of your employer's matching program is like getting free money, and is an excellent starting point when saving for retirement. For example, if you earn $50,000 and your employer will match all of your contributions up to 4% of your salary, this is like getting a $2,000 "bonus" on top of your salary.
The problem is that simply taking advantage of your employer's match might not provide you with the lifestyle you want throughout a long retirement. As an example, let's say you earn $50,000 per year, are 30 years old, plan to retire at age 65, and that your employer will match all of your contributions of up to 4% of your salary. By age 65, your 401(k) could be worth approximately $750,000, assuming 7% average annual investment returns. This might sound like a lot of money (and it is), but keep a few things in mind.
First, this money needs to last for the rest of your life -- what if you live to 100 years old? Experts generally recommend that you withdraw no more than 4% of your account's value each year in order to ensure your money lasts as long as you do. And, given our hypothetical 401(k)'s value, this translates to $30,000 per year. Even when you account for Social Security, this might not cover your expenses.
Additionally, don't forget about inflation. Even if $30,000 per year sounds like enough, a dollar today won't be worth a dollar several decades from now. At a 2% average inflation rate, $30,000 would be worth just over $15,000 (in 2015 dollars) in 35 years.
What does it mean to "max out"?
The IRS allows you to contribute $18,000 of your salary to your 401(k) this year, but saving that amount of money isn't practical (or necessary) for most people. However, by "maxing out" your 401(k) contributions, I simply mean you should contribute as much as you can reasonably afford to save without putting undue pressure on your current lifestyle.
You might be surprised at the impact just a small increase could have on your long-term financial health. If you're 35 years away from retirement, as in the previous example, and can contribute an extra 3% of your salary, it could mean an additional $16,000 in retirement savings, and that's from your contributions for just this year.
To give you an idea of how much of a difference it could make, look at the potential long-term impact of an increased 401(k) contribution rate on your retirement nest egg.
Now is the most important time to boost your contributions
The most powerful wealth-building force you have at your disposal is time, as the longer your money grows and compounds, the more your nest egg will increase over the years. And, since you'll never be further away from retirement than you are right now, the money you put into your 401(k) now will have the biggest impact.
If you're 30 years away from retirement, every $1,000 you put in your account could be worth an extra $7,600 by the time you retire, assuming the same 7% average returns I mentioned earlier. On the other hand, once you're 20 years away, the long-term impact of every $1,000 drops to about $3,870.
So, while all of your 401(k) contributions are an important piece of the puzzle, none will be more valuable to your nest egg than the contributions you make right now.