If you've received a salary increase this year, congratulations! You may already have some ideas about how you want to use this extra money, but here's one you may not have considered: increasing your contributions to your retirement account. It may not be as exciting as making a large purchase or going on a trip, but it's a much better investment over the long term. Here's how boosting your retirement contributions can help you today and in the future.
Short- and long-term benefits
When your salary increases, your tax liability will as well. It's possible that you could end up in a higher income tax bracket, where you're losing a larger percentage of your income to the government every year. This could negate some of the value of your raise.
But if you contribute a portion of your increased earnings to a 401(k) or traditional IRA, you will reduce your taxable income for this year. You can contribute up to $19,000 to a 401(k) in 2019 or $25,000 if you're 50 or older; it's $6,000 to an IRA or $7,000 if you're 50 or older.
But you see the real benefits of increasing your retirement contributions over the long term. The money in these accounts benefits from compounding over time. This means that, at first, you earn interest on your initial contribution, and then over time, you begin earning interest on your interest as well. The more you contribute and the longer the money compounds, the more you will have in retirement.
Let's assume that you were making $45,000 per year, and you were contributing 10% ($4,500, or $375 per month) to your retirement. Then, you got a $5,000 raise, bringing your annual income to $50,000. If you didn't make any changes to your retirement contributions, you would now only be contributing 9% of your income instead of 10%. If you contributed that same amount every year, you would end up with just over $425,000 after 30 years, assuming a 7% rate of return.
But now imagine you boosted your retirement contributions when you got that raise. You contribute the same 10% of your salary every year, but now that amount is $5,000 per year, or about $417 per month. After 30 years, you will have nearly $473,000, again assuming a 7% rate of return. That's a difference of $48,000, all from contributing an extra $42 per month to your retirement. And that's not even considering any employer match. If your job matches a percentage of your salary, this will also increase with your raise.
What percentage of my salary should I contribute to my retirement?
There isn't an arbitrary percentage of your salary you should contribute to retirement. Some say 10%, others say 15%, and still others 20%. But every person's needs are different. It all depends on how long you live, how long your retirement will be, and what kind of lifestyle you hope to have.
There's no way to know this with certainty, but you can estimate it. First, think about how long you believe you'll live. The average life expectancy is 78.6 years, but you may live longer or shorter than this, depending on your genes and lifestyle. It's best to figure on the high side, just to be safe. Subtract your preferred retirement age from your estimated life expectancy to determine how many years of retirement savings you'll need.
Then, estimate your living expenses in retirement. Add up your monthly expenditures -- housing costs, utilities, groceries, and the like -- keeping in mind that some expenses you have now may go away in retirement. Multiply this number by 12 to get your annual expenses. Next, you must factor in inflation. A good estimate is 3% per year, so if you need $35,000 to cover your living expenses this year, assume $36,050 for next year, and so on. A retirement calculator can do this math for you.
Finally, subtract money you expect to receive from other sources -- like Social Security, an employer 401(k) match, or a pension -- to figure out how much you need to save on your own. If you don't know how much to expect from Social Security, you can estimate your benefits by creating a My Social Security account.
You won't need to set aside all that money out of your own paychecks because you'll have compound interest on your side. It's impossible to say how your investments will perform over time, but a 5% annual rate of return is a good assumption if you're trying to be conservative. Use a compound interest calculator to estimate how much your investments could grow between now and your retirement, and try to boost your contributions if they're not enough to reach your goals. If you can't do that, look for ways to reduce your expenses today (like limiting how often you dine out) to free up more cash for retirement.
Every time you get a raise, it's a good idea to reevaluate your retirement plan and think about how this new income will affect it. Boosting your retirement contributions by just a small amount can make a big difference over time and will likely prove to be a lot more valuable than any large purchase or trip.