What is the ideal contribution to a 401k?

I contribute about 10% to my 401k. I want to know more about Roth IRAs. I have one with my company, but haven't contributed any percentage yet as I am not sure how much I should contribute. What exactly is a Roth IRA? Additionally, what is the ideal contribution to a 401k for someone making $48K a year? 

 

 

401(k), IRAs
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June 2016

Great questions. First, let me address the question about "what is a Roth IRA?"

A Roth IRA is a retirement plan (a tax label as I tell clients) that means your contributions are made after-tax and distributions (as long as they have satisfied the Roth IRA requirements) are taken out tax-free. Roth IRAs also enjoy tax-free growth. You can read more about Roth IRAs here.

However, chances are your company has provided a Roth 401k option to you. This is similar to a Roth IRA, but can vary slightly. One difference would be you're not subjected to the same contribution limits. In a Roth IRA, you can only contribute $5,500 per year for someone under the age of 50 ($6,500 if you're 50 or older). However, a Roth 401k option would allow you contribute up the 401k max contribution limit, which is $18,000 per year as of 2016 ($24,000 if you're 50 or older). The Roth 401k also has no income limitations while the Roth IRA does.

Regarding your question about how much should you ideally contribute to your 401k....

The answer to this unfortunately involves many variables like:

-when do you plan to retire?

-what will your income requirement be during retirement?

-how are you choosing to invest your money now and what rate of return can your realistically expect from now until you retire?

-do you have any other sources of retirement income (like pensions, social security, etc.) and what is the total income generated from those accounts?

In general, I think 10% is a healthy contribution starting point. If your employer matches, that will also help you save faster. But, if your goals are to retire early or spend a lot in retirement, you may need to look at increasing what you're doing, especially if you don't have a company match. The answer to this question entirely depends on your retirement goals and other income sources. Social Security SHOULD be there for you, but based on your age, you may need to count on a reduced benefit if no legislative changes are made. In fact, you should expect a 20% reduction in benefits if no legislative changes are made by the year 2034.

Regarding your question about how much to save to a traditional 401k vs. a Roth option....

This depends on your tax situation. If you think you will be in a higher tax bracket in retirement, then you would want to contribute a higher percentage toward a Roth option today. This way, you'll pay taxes today (when you're in a lower tax bracket) and you won't have to pay taxes in the future. However, if you're like some that experience a lower tax bracket in retirement, then you'd be better off contributing to a traditional option. This way, you put off paying taxes until you hit the stage that you're in a lower tax bracket. It may be hard to predict what your tax situation will look like down the road, so it's not a bad idea to diversify your money into different tax buckets. In other words, do some to a traditional option and some to a Roth option.

I hope this information helps and good luck to you!

Joe Allaria, CFP®

June 2016
June 2016
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June 2016