Many people hope to retire with a big nest egg of money in their 401(k), but only a minority of people are taking one simple step that separates the best savers from the average.
Last year, just 37% of workers increased their 401(k) contribution rate, according to data from Fidelity Investments. Increasing contributions every year is one of the best ways to supercharge your retirement savings.
There's a simple system you can use to increase your contribution rate without feeling the pain of taking home a smaller paycheck. Some plans allow you to automatically enroll in such a system, and the vast majority of people increasing their contribution rate took advantage of that automated system last year. Here's the secret to joining the group of workers saving more every year.
Image source: Getty Images.
If you can't save more of your current paycheck, save more of your future paychecks
The simplest way to increase your contribution rate every year is to save a significant percentage of your future raises. Many workers receive an annual pay raise with their annual review. If that's you, you simply need to commit to saving a certain percentage of any future raises in your 401(k).
Importantly, you can't commit to save the same percentage of your raise that you're currently contributing. That's not going to increase your overall contribution rate. The increase needs to be substantially higher than your current contribution rate.
That may seem daunting, but if your raises exceed inflation on average, you'll find your cost of living can still increase while you set aside a larger portion of your paycheck.
Some plans can institute this automatically. Participants who use the automatic increases have seen huge increases in their contribution rate using the strategy. It's especially effective because you only have to decide once, and the rest happens without any human intervention needed.
If your plan doesn't offer an automatic increase, you'll have to do it manually. Committing to a certain percentage ahead of time can still produce great results. That said, you'll still need to muster some self-control. When your boss gives you a $5,000 raise, setting aside a big chunk of it can be tough, even if you've already said you would.
Increasing your contributions adds up fast
Increasing your contributions by committing to save a meaningful portion of any raises can add up to hundreds of thousands of dollars over the course of a person's career.
Compare two people with the same starting salary of $50,000.
- Person A decides to contribute 5% of their salary to their 401(k) and never changes that rate.
- Person B decides to contribute 5% of their starting salary to their 401(k) and will add 25% of all future raises to their contribution.
- The company fully matches the first 2% of salary contributed and 50% of the next 4% in salary contributions.
- It also gives each worker a 3.5% annual raise.
If they both invest in a simple index fund that returns 7% after fees, they'll end up with drastically different balances by the end of their careers. Here's a look at how the two compare.
| Year | Person A Balance | Person B Balance |
|---|---|---|
| 1 | $4,385 | $4,385 |
| 5 | $26,918 | $32,063 |
| 10 | $69,723 | $94,713 |
| 15 | $135,760 | $203,055 |
| 20 | $235,507 | $379,324 |
| 25 | $383,872 | $655,427 |
| 30 | $602,013 | $1,076,973 |
Table source: Author. Calculations by author.
While the person who consistently invests 5% of their salary (plus their employer's matching contribution) every year ends up with a respectable 401(k) balance at the end of 30 years, that number's dwarfed by that of the person who increased their contributions with every raise. Person B also gets a boost by maxing out their company match starting in year three, while Person A continuously leaves 0.5% of their salary in "free money" on the table by under-contributing. By year 30, Person A is contributing 17.6% of their salary, and their employer adds another 4% of that salary.
Keep in mind that the above example assumes consistent market returns and annual pay raises. Things don't work that way in real life. You can't count on the market returning the same amount every year, and you can't count on receiving a raise every year either. But if you can set aside a good chunk of your future pay raises to save for retirement, you'll find yourself with a very healthy 401(k) balance by the time you retire.
