If you’re just starting out, saving right away for retirement in a 401(k) plan is the best way to begin your journey to financial independence.
A question I often receive from newly employed young people is how much money they should contribute to their 401(k) plan at work.
The answer is simple: the amount you contribute should be dependent upon how much of your net pay you need for living expenses.
Many companies match employee contributions to the 401(k) plan up to a certain amount, so the best case would be to take full advantage of what the company offers.
Many times, young people are apprehensive to put away too much at first because they believe they won’t have enough money to pay bills.
However, what they don’t realize is that when this amount is broken down into smaller chunks, it may not be too much at all.
Here is an example. Suppose you make an annual salary of $30,000 working for a company that offers to match 3% of your salary if your contribute 6% of your paycheck.
Doing the math, this means you will need to contribute $1,800 for the year to get the match. That may seem like a lot of money to someone first entering the workforce, but over 24 bi-monthly pay periods it amounts to $75 a pay period.
Of course, even that may sound like too much. But, before dismissing it, you should know that the reduction in take-home pay is really less than $75. That’s because contributions to a 401k plan reduce an employee’s taxable income. Less taxable income means less tax withheld from your paycheck.
So, a $75 bi-monthly contribution to your 401(k) may only reduce your net take home pay by $50.
Your employer is putting 3% of your gross pay, or $37.50 per bi-monthly pay period, into your 401(k) plan. Together with the $75 you are contributing, that totals $112.50 at a cost of only $50 less take home pay. That’s like someone asking for singles, and giving you a $10 bill in return.
While the numbers seem small, availing yourself of the match can really add up over the long run.
Using the example above, taking full advantage of the match results in 1.5 times more money after 40 years (assuming a 6% growth rate) than no match at all. This also assumes no salary increase over the 40 years. With salary increases, the difference would be even greater.