Maximizing your 401k contribution: We know why, the big question is how?

 

Many of us, if employed, are eligible to participate in a company sponsored retirement plan which allows us to personally defer (contribute) a significant amount of our earnings to the plan on a tax-favored basis.  In essence, our Federal and State tax codes incentivize us to save for our retirement.  For those of us who are self-employed, it’s easy to establish a similar plan.  Depending on the plan type, the contribution limits are as follows:

  • 401k, 403b, and 457 plans: $18,000 per year ($24,000 per year if age 50 or older).
  • SIMPLE IRA and SIMPLE 401k plans: $12,500 per year ($15,500 per year if age 50 or older).

In theory, contributing the maximum to our retirement plan seems like a really good idea.  And given the pressures on Social Security and the steady decline in pension plans that pay retirees a guaranteed income at retirement, there is an overwhelming need to do so.  But the reality is many of us are not saving the maximum and are losing a golden opportunity to create financial security.

But why the emphasis on contributing the “maximum” amount?  Many employees are being encouraged on the worksite to contribute just the minimum amount that will earn the matching funds from their employer. Usually this is in the range of 3-4% of salary.   This is a start, but for most people it is not nearly enough and by waiting too long to begin a meaningful savings pattern, employees miss out on the most powerful engine in retirement planning:  Compound interest, or the time value of money.  Here is a simple way to demonstrate this.

  • An employee who starts contributing the maximum of $18,000/year at age 35 and earns an average of 6% per year will accumulate $1,508,430 by age 65.
  • An employee who waits until age 55 to contribute $18,000/year and earns 6% per year will accumulate $251,489 by age 65.

I’m pretty certain that no one is opposed to saving more for moral or philosophical reasons. For most of us, it boils down to one very practical obstacle. We struggle with managing our cash flow (spelled B-U-D-G-E-T). Low savings rates and excessive debt levels are just symptoms.

The truth is, there is a science to cash management and most of us didn’t take that course.  If the process is too complicated or takes too much thought and effort each month, we are prone to avoid or abandon it.  But the right approach, a combination of good tools and an easy intuitive method that can operate on automatic pilot, will be highly effective and folks often go from frustrated and stressed to wondering why they waited so long and what all the drama was about. Over the past 30 plus years of advising clients, I’ve seen firsthand how everyday people who master the budgeting process become the quiet millionaires next door.

Winfred Jacob, CFP®
Senior Financial Advisor

Winfred Jacob
Winfred Jacob