Planning for retirement is a complex process that starts with an easy first step: saving money. A commitment to regular savings, as early as possible, will launch your retirement planning in the right direction.
As you get closer to retirement, you may want to be more purposeful about your savings. "How much should I contribute to my 401(k)?" is one of the most common questions that financial services folks hear.
Figuring out how much to put in your 401(k) depends on your overall goals and financial situation, so it will vary for each person. The amount you can save is also determined by the Internal Revenue Service (IRS), because there are limits on how much money can be put aside.
401(k) contribution limits
For 2020, the IRS allows 401(k) participants to set aside up to $19,500 per year. If you are older than 50, your plan may allow you to contribute an additional $6,500 per year as a "catch up" contribution. Keep in mind that your plan may not allow you to make the full contribution. (The IRS frowns on corporate retirement plans that favor senior executives, so they limit the amount of money that an employee can deduct if only the most highly compensated employees at a company are participating in the 401(k) plan).
To encourage people to participate in the retirement plan and to reward good performance, many companies will match employee contributions to the 401(k) plan. This is free money. All you have to do to receive it is participate. If you are just getting started and do not have a lot of money to spare, find out how much of a match your employer provides and contribute at least enough money to receive it.
Other obligations such as student loans, mortgages and raising children may get in the way of your good intentions. That's why it's important to establish the savings habit early. Even if you cannot save as much as you would like, the employer match and compounding of investment returns over time will get you closer to your goals than if you did nothing.
Make a saving plan
America Saves Week, an organization dedicated to promoting savings, found that people with a specific savings plan were more successful in saving money than those without a plan. Their research has shown that those with a plan are nearly two times as likely to spend less than they earn and save the difference, In other words, establishing the habit of contributing to your 401(k) is as important as saving a large amount.
Because of how life interferes with well-intentioned savings plans, the IRS allows catch-up contributions because many people can't put enough money away for retirement early in their careers. At the same time, some people often spend less money when their children leave home because they can pay off their mortgage and enjoy lower household expenses.
Unfortunately, a lot of taxpayers aren't getting the message. Researchers at the Center for Retirement Research at Boston College have found that households tend to reduce mortgage debt but not otherwise increase savings rates when their children are grown. Thus, the lesson should be: You might save more when you're older, but you're better off getting into the habit when you're young.
Don’t cash out your 401(k) early
Another lesson: Whatever you do, don't cash out your 401(k) savings. If you leave your job, you are allowed to spend your 401(k) funds - if you pay taxes on the amount, including a 10% penalty tax assessed on most withdrawals made before age 59 ½. You may be tempted to take the cash and spend it on a vacation before you start your next job, but that's not a very good idea.
Roll over that retirement money, sign up for the retirement plan with your new employer and take a nice and affordable staycation instead. Your retired self will be very grateful to your working self for making a small sacrifice that could have a big impact down the line.
Next steps to figuring out how much to put in your 401(k)
If you’re unsure about how much you can afford to contribute to your 401(k), check out our paycheck impact tool that can help you calculate an exact number based off your salary and employer match options. If your employer doesn't offer a 401(k) matching plan, don't fret. There are still many ways you can save for retirement.