Deciding on How Much We Can Put Into a 401(k)
If our contributions are being matched, and we are a typical investor that is comfortable enough with going with the funds that our plan provides, we are going to want to max out our 401(k) before we look into moving toward an IRA, at least in our working years.
After we retire, rolling over the money into an IRA and especially a Roth IRA will make sense, but this is after we’ve left our employer and the work force and the matched contributions have stopped.
If our employer has a 401(k) plan and does not match our contributions at all, it can make sense to max out our IRA first and then contribute to the 401(k) if we have more that we can contribute, if we desire the additional flexibility that IRAs offer. IRAs give us a lot more control over our investments, but if we’ll be just investing in the same sort of things that the funds in the 401(k) do, with the same strategies, then it won’t really matter and we could just go with the 401(k).
Deciding on how much we can set aside for our retirement needs will always essentially come down to our choosing to defer income to the future, as well as taxes. This means in most cases that we need to decide what we can spend less on now, and only the truly rich have money that they cannot envision spending.
What we should be doing when deciding on what to contribute to retirement is to look to smooth out our lifestyle, where ideally there would be no loss when our earning years end. This will require us to have a very good amount set aside, enough to replace at least most of our income when we retire.
Although our expenses in retirement will go down, they usually don’t go down by all that much, only by whatever extra amount that our working required us to spend, things like extra transportation costs, perhaps meals at work, higher clothing costs, and other incidental expenses related to our employment.
If our tax bracket is reduced, then we’re also going to be able to get by with less gross income, and it is net income that we always want to be concerned with here whenever we project needed incomes in retirement to maintain our desired way of life.
Maintaining a sufficient income in retirement is a tall order though, as we at a minimum need enough so that we can keep up with things when our earnings from employment end. If we need to replace $50,000 for instance, and expect an average return of, say, 5%, we’re going to need a million dollars in our retirement account to achieve this.
To make this even more challenging, we can’t just look at market returns here, we need to be instead concerned with returns net of inflation, real returns in other words. If our return is 5% but inflation is 2.5%, this means that we’ll need twice this, in this case two million dollars, to avoid us spending down our principal.
People do spend down principal amounts in retirement, but we can’t be doing too much of this lest we outlive our funds and end up broke and unable to maintain even a reasonable lifestyle, and live out our final years as paupers. This is what we are looking to avoid when we save for retirement and need to make sure we are prioritizing it enough to at least minimize the pain that retirement may inflict upon us.
For most people, this will involve hard decisions, where we will have to tone down our spending and our lifestyle, setting aside more of our discretionary income toward our retirement fund. The smoothing that we should be shooting for here involves both propping up our situation in retirement and pulling back while we are working to seek to balance things more.
Matched Contributions and Future Value
While striving for a balance between the present and the future is the primary goal of saving, and especially with saving for retirement, the fact that many employers match our contributions and we also benefit from tax savings both skew things toward preferring future benefits over present ones.
The main principle behind saving for retirement is diminishing marginal utility, which tells us that we get the most value out of the first dollar we have, with each subsequent dollar being worth a little less.
If we imagine just having enough money to survive, that amount will be the most important because without it we will simply die, of starvation for instance or exposure to the elements If we lack either food or shelter.
Beyond that, there will be an amount that can have us living minimally comfortable, and then reasonably comfortable, and beyond that, we will still get utility or happiness out of additional amounts but the effect will be lessened as the amounts rise generally.
If we can spend either $20,000 on a modest car or $60,000 on a luxury car, we’re going to probably enjoy the luxury car even more, but if we instead set aside this extra $40,000 for the future, this can end up being quite a bit more valuable to us if it means using it to avoid living in squalor later on.
401(k)s add additional reasons to save for the future though, and this starts with tax savings. We can either pay less tax on the amounts we save, or with a Roth plan, we can avoid paying tax at all on the earnings that our retirement savings generate.
On top of this, if our employer is matching our contributions to some degree, which is generally the case with 401(k) plans, this is all the more reason to delay our enjoyment of amounts of money that we can afford to defer to the future.
In our example, if we put this extra $40,000 into our 401(k), since this is net money, if we are in a 28% tax bracket, this means that we actually will be contributing $55,555 in pre-tax money. If our employer is matching our contributions at 50%, we’ll actually have $85,555 put into our account instead of just spending the $40,000 after-tax money on the car upgrade.
This money will earn more, and even with a net return over inflation of just 3%, in 30 years we will have $168,544 in today’s dollars at retirement. This equates to spending the money now or having a full four times the money later, when we will need it more.
This really shows the power of employer matched 401(k)s, and how we really need to take this into account when we decide what proportion of our discretionary income to spend now and how much to set aside for the future. From an economic perspective, we definitely should be strongly preferring the future to the extent that we can comfortably manage it.
In reality, few people take this into account anywhere near enough, even though the benefit of employer contributions to our retirement fund is quite transparent. This does very often work in encouraging employees to contribute more to their retirement, although few people realize just how big of an advantage 401(k)s represent over spending money now, and if they did, they would definitely be working harder to put more money into one.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
Contact Robert: robert@marketreview.com
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