Ahhhh, the 401k. I know so many people who don’t understand how the 401k works and not maximizing its benefits. If you are wondering how much to invest in your 401k, the short answer is: AS MUCH AS YOU CAN AFFORD TO. (Max contribution per year is about $17,500)
What is a 401k?
401k is a retirement plan where you are allowed to put pre-taxed money to grow and some employers offer to match your contribution. Typical company matches would be like 100% match up to 5% of your salary or 50% match up to 6% of your salary.
Here’s an example with company match
- My company offers a 100% match up to 5% of my salary.
- Let’s say I make $100,000 just for mathematic simplicity.
- Let’s say I put in the minimum to receive ALL the company match. The company will match 5% of 100k, which is $5000, so I will put in $5000.
So by taking advantage of the company match, I am instantly getting a 100% return! Now I get to earn about 7% (investing in the S&P500) on $10,000 worth of money in my 401k. That’s pretty awesome! It gets better too! Since I put my $5000 pre-tax, it lowers my income to 95k, so I save taxes on $5000 which is like $2000!
If you choose NOT to invest in the 401k, you get paid on that $5000, but you get taxed on it yielding you about $3000 in your pocket.
So in reality, the $3000 post-tax investment into the 401k has yielded in me having 10k in my 401k and a tax savings of 2k. Now if I let that 10k, grow at 7% for 30 years, it turn into $81,661.70. I can add $2000 to that which I got to save in taxes as well, so that is an effective value of $83,661.70 from a $3k (post tax) investment of my money.
A $3000 investment with company match turning into $83,661 over 30 years in terms of APR is about a 11.1% return.
That’s a pretty good return!
401k without company match
Let’s run the calculation without the company match. This means I have $5k in my 401k after my 5k contribution. 5k grows for 30 years at 7% which turns into $40,830.85. I still get to save $2000 in taxes which makes an effective value of $42,830.85.
A $3000 investment without company turning into $42,830.85 over 30 years in terms of APR is about a 8.86% return.
That’s not too shabby too!
So what does all that math mean?
If you don’t have another investment opportunity that will yield over 8.86% then you are better off putting as much as you can in your 401k even if your company doesn’t offer you a match.