What Does It Mean To Put Away 10% Of Your Salary For Retirement?

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A reader wrote in with the following question:

I have read in many places that you should maximize your 401(k) contributions. To me it seems there are MANY definitions of maximizing this and I was wondering what you mean when you say you should be saving at least 10% of your income for retirement. Right now, I am contributing 5% of my income to my 401(k) program and my company is matching me one-to-one on this, so a full 10% of my pay is going into retirement savings, but using this method I don’t reach the maximum allowable contributions. So which is really maximizing my retirement savings? When you say 10% do you mean total including matching, or do you mean 10% from you yourself not including matching?

The advice to maximize one’s 401(k) contributions is solid advice, but it may not prove a realistic target depending on your income or family situation. Instead, many people recommend putting away 10% of your pretax income into some sort of retirement savings vehicle. Depending on how early you get started (the earlier the better – if you get started in your early twenties like I did, you’ll be just fine), 10% may in fact be all that you need the whole way along, but if you’re getting started later, you may need more than 10%.

Let me use an example of one of my friends, who makes about $40,000 a year but does not have a 401(k) at work. I advised her to start contributing to a Roth IRA immediately and maxing it out through automatic withdrawals from her paycheck, which she has started doing. She’s 22 years old, and if she invests $4,000 a year (which is 10% of her income right now) and earns only a 10% return on that money, when she reaches the magic age of withdrawal (59 1/2), she’ll have almost $1.5 million in there. While this won’t cover her retirement needs entirely, it will certainly help, and if she keeps increasing her contributions in parallel to her earnings all the way along, she’ll be in very good shape.

So, what about that 10%? Should you count your employer matching toward that number? My belief is that you should not count your employer’s match towards your 10% – you should view it as an immediate return on your investment as soon as you deposit it. In general, you’re always better to err on the side of having too much in retirement savings than not enough, because if you have “too much” when you start tapping it, it’s not a problem, but if you don’t have enough, then it can be a problem.

Let’s use another example. Joe is 25 and makes $30,000 a year. Over his life, Joe will average a 6% increase in salary each year until the day he retires at age 65 and starts tapping into his 401(k). His employer offers an equal match on the first 5% Joe puts into his 401(k), and the investment will earn an average of 10% a year. If Joe just puts in 5% and gets the match, he’ll wind up with $2.9 million at the end, a nice nest egg, but not a strong one in 40 years. By just contributing 5% more, Joe bumps that up to $4.4 million, which will put him in much better shape.

One more thing, though. If you are eligible for a Roth IRA (if your income is below $110K, you are), you should put money into one of those instead of putting unmatched money into a 401(k). Why? The income you earn from a 401(k) will be taxed when you withdraw it, but the income from a Roth IRA will be tax free. In other words, when you get money out of the 401(k), you’ll have to pay some percentage of it immediately in taxes, but not with the Roth IRA. It’s not as good a deal as the matching that you can get with a 401(k), but it’s better than putting money into a 401(k) unmatched.

So, here’s the plan: put money into your 401(k) as long as it’s matched, then put money into a Roth IRA, then put what’s left of your total 10% into your 401(k) plan.

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18 thoughts on “What Does It Mean To Put Away 10% Of Your Salary For Retirement?

  1. “Over his life, Joe will average a 6% increase in salary each year until the day he retires at age 65…”

    Good article, but I have two criticisms. First, I want to know which company Joe works for. I would love to get a 6% raise (or 5%, or 4%) for each year I work. The last year Joe works he gets a $17,466 pay raise.

    Where I work, the pay raise is based on dollars, not percentages. That is because I have a pool of dollars to give out, not a pool of percentages. I may give someone who earns $100K a 3% pay raise for being an average worker which amounts to $3,000. I may give another person a 6% pay raise for (you guessed it) $3,000 since they are paid $50,000.

    Second, you need to take into account inflation, which is running 3% ~ 4% on average (if you believe the government … but that is a story unto itself).

    Still, it is a good article and its advice is one that I have been following since Joe’s age.

  2. I don’t think your advice on Roth IRAs is sound. You’re ignoring the one major disadvantage of a Roth IRA. Contributions are not tax deductible! This is as opposed to a 401K or traditional IRA, which are funded with pre-tax dollars.

    A simple example. If you had $100 to invest, would you rather I take $30 (30%) today, leaving you with $70 to invest, or would you rather I take 30% when you’re done investing? If over the lifetime of the investment it appreciated 300%, in the first scenario you’re left with $210. In the second scenario you’re left with $270!

    Roth IRAs do have their advantages, but they revolve around the belief that you’ll be in a higher tax bracket when you retire than when you’re working. This may be the case early on in one’s career, but very likely not the case later.

  3. Ok the math in my example is totally bogus (I blame the hangover). But my point is that it’s not as clear a choice as the article suggests. It depends on what tax bracket you’re in and what tax bracket you expect to be in.

  4. If your tax rate in retirement is the same as your tax rate now, a Roth IRA will give you the exact same benefit as an unmatched 401k. Now many 401Ks have poor investment options so unless you need the tax deductions, Roth IRAs often can be the better choice.

  5. maximizing 401k means that you invest to the limit of benefiting matching contributions. now, this is within the larger framework of your overall retirement savings plan. It makes no sense to invest 10% of your income into 401K if you will reach your retirement goal with only 5%. figure out your end game and then adjust your contributions towards it. if you have left over $$ have fund and spend it.

  6. Hi Trent,
    What I want to know is how to balance paying off credit card debt along with saving in one’s 401K. We have over 20K of credit card debt. We’ve been focused on paying off that debt. I just got a 7% raise and I upped my 401K contributions from 5% to 15%. Now I’m thinking that may not be prudent. Perhaps I should leave it at 5% and focuse on paying off the debt before increasing the 401K. What do others think?

  7. I wondered if matching was putting away $15500 a year (the most the government allows) in the 401k or putting up to the employer match. As my employer offers a 401k but with no matching whatsoever, and I can’t put away a full $15500, I find the advice to max my 401k totally worthless.

  8. js: It’s not worthless just because your employer doesn’t match. You’re also forgetting that the money you put into your 401k will NOT be taxes.

    ladydough: my advice is if you’re able to get the matching employer donation to your 401k, assuming their is one, to do that. And then use the extra money from the raise to pay down your credit card debt. Just make sure you try out one of those 0% balance transfer offers.

  9. MossySF

    the tax rate in retirement has nothing to do with an unmatched 401K being better. yes the money goes in pre-tax but you’re going to pay taxes on that money and any interest gains when you take it out. With a roth you’ll pay taxes upfront on contributions but all the interest you made for 40 years is tax free.

  10. A couple of your numbers are off, Trent. Most people don’t average a 6% pay raise every year. I believe 3-4% is more what people can expect without changing jobs. That figure is just about in keeping with inflation. People will change jobs, but it could be a 10% jump one year, followed by 3% increases for several years after that.

    Also, an investor’s average rate of return is not 10%. It’s closer to 8%, with 6% being a safer bet after inflation. The total market may have an average of 10% growth, but the market is not the same as the average investor and the average investor can’t expect to track the entire stock market entirely.

  11. Consider your whole picture. With the 401k you get tax relief now. With the Roth IRA you get it later, maybe. Although it will not be taxable the government can still find ways to make you pay like using it to disqualify you from other programs or limiting how much you can withdraw each year. All of these are just laws that can be changed. Its a social contract for the future and Congress always finds a way to separate us from our money when they want to. When I started contributing to Social Security(SS) it was with the understanding I would collect at 65 and they’ve changed it to 67. It also was an account that if I did not use all my contributions to SS by my death my relatives could request the balance of, but not anymore. I still believe in contributing toward retirement, as much as you can or at least 10% but consider the benefits for today as well as tomorrow.

  12. Something else to consider is how much your 401k costs you in expenses each year vs the cost of the Roth IRA. And, some 401k programs have very poor investment options. The Roth IRA is much more flexible with investment options and costs.

  13. Kevin, try doing the math.

    Roth IRA – Earn 5K, pay 20% tax, contribute 4K. 10 years of 10% growth. 4 * (1.10 ^ 10) = 10374.97

    401K – Earn 5k. 10 Years of 10% growth. 5K * (1.10 ^ 10) = 12968.71. Pay 20% Tax = 10374.97

    The numbers match up exactly. Multiplication is commutative. You can apply the 20% tax before contribution or after withdrawal. The order does not matter.

  14. MossySF is right, the only variables are the relative performance of the funds availabe in the 401(k) or Roth and the tax rates around at each time.

    I always assumed that maximising your contributions meant putting in as much as legally allowed. In the UK, that would be difficult to do as you can essentially contribute your entire earning to similar schemes.

  15. he is and he isn’t.

    He is assuming that you have little or no deductions to your income. While I may be in the 25% tax bracket I really paid under 5% last year. Once I’m older a lot of the deductions I enjoy now would not be available to me so I would be paying the full tax rate on any money I receive.

  16. If you have deductions (before the 401k/traditional IRA) that take you out of the 25% marginal rate, then you are not in the 25% marginal rate. It’s that simple. Do the projections and calculations based on what you do pay — not what you might pay if you had a brain fart and claimed no deductions at all. So if you believe in the future you won’t have the same deductions, then the correct answer is you will pay more taxes in the future — not “my taxes are the same but actually different”.

  17. plonkee, also the fact that any matching 401k contributions weren’t included in the calculations.

    ladydoughgirl, it would all depend on if you getting matching contributions. i’d still contribute to 401k as normal with half of the pay raise if you are getting matching contributions. use the other half to pay down credit card debt. you want to have a big picture even though you are $20k in debt. if you haven’t funded an emergency fund, then i would either go 1/3of raise into each (i.e. e-fund, cc debt, and 401k), or you could do half of raise into e-fund until fully funded, and half towards cc debt. after e-fund funded transfer that towards your 401k. focus on the bigger financial picture rather than just saving or just paying off debt. You need to do both, which you are.

  18. I have contributed 10% of my income to a 401K since I was 24 years old. I am now 48. I have $200K in my 401K plan. Everyone talks about a 10% or 5% or 15% return but no one ever mentions when the markets drops (as it has at least 3 times in the last 20 years) and you lose 30% of your invested savings in one fell swoop.

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