Most people who have a 401(k) plan at work contribute to their account to take advantage of their employer's matching contributions. And why not? Your employer's matching contributions are essentially free money and can help you build a retirement nest egg with relatively little effort or expense on your part.
However, if you can afford it, you might consider boosting your 401(k) contributions beyond the amount your employer will match. As you'll see, even a small increase could make a huge difference in your quality of life in retirement.
The big difference a small increase can make
Let's say you earn $80,000 per year and your employer is willing to match your 401(k) contributions up to 4% of your salary (the average employer match in the U.S. is about 4.5%). So you contribute 4% of your salary to obtain that "free money" from your company.
Your contribution and the employer match add up to $6,400 in total contributions to your 401(k) during your first year. Assuming annual raises of 2% and investment returns of 8% (less than the S&P 500's historical average), this would build to about $880,000 in 30 years. Not too bad, right?
It may not be enough, though. According to the traditional "4% rule" of retirement -- i.e., that you should withdraw 4% of your savings in your first year of retirement and then adjust that figure for inflation in subsequent years -- you can reasonably expect this amount of savings to produce about $35,000 in annual income once you retire. Even factoring in Social Security, will this support the lifestyle you want?
However, if you increase your contribution slightly to 5% of your salary, after 30 years your nest egg could be $110,000 greater, or just shy of $1 million. Also consider that in this example, 1% of your salary is just $800 per year, or about $31 per paycheck, assuming you're paid biweekly. Could you part with that much of your paycheck for an extra $110,000 once you retire?
Here's the difference higher contributions can make over the long run, based on the above assumptions.
|Percent of Pay Contributed||Employer Match||Balance After 30 Years|
Consider making incremental increases
One strategy that will make increasing your contributions relatively painless is to increase them by small increments. For example, you could increase your contribution from 4% to 4.5% this year and continue upward from there.
Or you could increase your contributions in step with your salary. If you get a 2% raise this year, put half of that amount into your 401(k). Your paychecks will still go up, but you'll still be making a big difference in your long-term retirement savings.
How much can you afford to contribute?
The IRS allows elective contributions (not including your employer's match) of up to $18,000 for the 2015 tax year, and you can contribute an additional $6,000 if you're over age 50. Even though your employer most likely limits the amount it will match, all of your contributions up to this amount will be tax-deferred, so your taxable income will be reduced by whatever you contribute.
While you might never max out your allowed contributions, it's important to save and invest as much as you can comfortably afford. Supercharging contributions to your 401(k) plan can enable you to build up a nest egg that's big enough to provide the kind of retirement you want.