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

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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