Financial Planning: How to Structure your 401(k) Plan
In today’s world of shrinking interest rates and fewer pension offerings, making sure to save early and often is critical for those who would like to retire comfortably. The most convenient and therefore popular method is the 401(k)
. Years ago, the main form of retirement funding was with an employer-sponsored pension plan, where the employer was responsible for ensuring the funds were sufficient. Today, the onus has been moved to the employee.
There is no clear cut answer to the title question because there are so many individual factors in play. Let’s look at the main factors and see if we can come up with a formula to help find your answer:
- Age will forever be the most important factor. Age can be broken down into two separate parts; actual age and retirement age. If a person is 45 and wishes to retire at 55, he will need to have much more in his 401(k) than the 25-year-old who does not plan on retiring until she reaches age 65. As such, the general rule for younger generations is to save between 10-15% of total income. As one approaches the late 30s to early 40s the number increases to around 20% for those who fell behind, and grows exponentially afterwards.
- Income. Again, this can be split into the current income piece, which is defined by how much a person is currently earning, and retirement income, or how much a person would like to earn in retirement. For example, a 35-year-old currently making $100,000 has a goal of retiring at age 65 with enough money to fund his post-tax income of $75,000, or $6,250/month. In order to meet those goals, assuming 15% annual contributions and 6% growth for the next 30 years, this person would need to have right around $200,000 already saved for retirement.
- Life expectancy. The final factor is guessing how long a person will live. Obviously no one can predict the future or foresee their own death, but most retiree’s biggest fear is outliving their money. Average life expectancy in the U.S. is right around 80, but that only tells a small portion of the story. A person who expects to die young, at 70, will need to have a lot less in their 401(k) come retirement than the couple expecting to live happily ever after until 95.
In conclusion, how much you should contribute to your 401(k)
is dependent upon yourself and your needs. If we all started at 15% at age 25 and continued at that amount, without withdrawals, until 65, we would probably all have enough money to comfortably retire. However, since most Americans do not adhere to this model, we need to come up with a better formula for those who may be starting later. My proposal is to start with the anticipated number of retirement years (let’s say 30) multiplied by the desired income ($75,000/year, $2,250,000 total). This gives us a gross principal need, so we can use growth to cover inflation. Once we have this number, an interest rate or retirement calculator can help us determine the x factor.
If we again assume 6% growth, and we know how much we plan on saving ($1,250/monthly or $15,000/annually in our example), we can plug that into our calculator and determine that we need to already have $200,000 in savings to meet our goal. Conversely, if we’re a bit behind, and only have $50,000 saved, we can use the same calculator to figure out that we must boost our savings rate to $25,000 per year or 25% of our example’s $100,000 income. With the 2016 limit being $18,000 into a 401(k), this scenario requires a maximum 401(k) and IRA contribution, plus a bit more. To use your own figures and determine where you should be in 401(k) savings and how much you need to continue to save, here is an interest rate calculator
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