Among Americans who contribute to a 401(k) or similar retirement plan, the most common contribution amount is just enough to take advantage of the employer match. For example, if an employer is willing to match its employees' contributions dollar for dollar up to 5% of salary, the average worker will contribute 5% of their salary to take advantage.
While this is certainly a good start, you're allowed to contribute a lot more to your 401(k) than your employer is likely willing to match. Here's how much you could end up with if you decide to max out your 401(k) contributions in 2018, and every year after that.
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What does it mean to "max out" your 401(k)?
For the 2018 tax year, American workers under 50 can choose to contribute as much as $18,500 to their 401(k), with an additional $6,000 "catch-up" allowance if you're 50 or older.
Keep in mind that this doesn't include employer matching contributions or any non-voluntary contributions -- it's just the money that you choose to have withheld from your paycheck and invested in your 401(k). Including employer matching and all sources, the overall limit for 401(k) contributions is $55,000 for 2018.
Here, then, is what a maxed-out 401(k) contribution could do for your retirement. For our purposes, we'll say that "maxing out" your 401(k) refers to the part of the contribution limit that you have control over -- your elective salary deferrals.
Let's say you're 35 and plan to retire at 65. If you contribute $18,500 to your 401(k) in 2018, based on an annualized 7% investment return, that figure could grow to nearly $141,000 by the time you retire. And that's not including the effect of any employer matching contributions.
Of course, there's no way to predict your investment returns, especially over a short time period, but as I've discussed before, a 7% average rate of return is reasonable to expect from a properly allocated portfolio of stock and bond investments over the long run.
What if you max out your 401(k) every year?
Here's the important part: One critical feature of any successful investment plan is consistency. In other words, the important thing isn't simply maxing out your 401(k) this year, although it certainly wouldn't hurt, but to contribute generously to your 401(k) every year. Doing so can produce a pretty amazing nest egg by the time you're ready to retire.
Consider the example of our 35-year-old 401(k) participant. If that person contributes $18,500 to his or her account every year, and then increases the contributions to $24,500 per year once turning 50, how much could that person have by age 65? Based on 7% annualized returns, these maxed-out 401(k) contributions could result in a staggering $2.05 million account value.
What's more, not only does this not include the effects of any employer match, but it assumes that the maximum 401(k) contribution limit remains constant over time, while in reality it adjusts annually for inflation. If you use each year's maximum, you're likely to contribute even more money along the way.
The Foolish bottom line
In reality, most Americans don't max out their 401(k), nor is it practical or even necessary for many people to do so. The point is that the 401(k) contribution limits are extremely generous, and when combined with the power of compound returns, investing as much as you can reasonably afford to contribute in a 401(k) or similar retirement plan can produce a pretty impressive nest egg over time.
