Employee Education: Class 101 – “How Much Should I Contribute to My 401(k)?”

Summary:

Now that we know the purpose of a 401(k), we can discuss what a 401(k) needs in order to be successful.

Agenda:

  1. Success Defined
  2. Working with your 401(k)
  3. 401(k) & the Car: A Parallel
  4. The General Rule of 401(k)
  5. Advanced 401(k) Planning
  6. Recap

 

1. Success Defined

Even with all of the advantages of a 401(k), it cannot succeed without you. For a 401(k) to be successful, it must have helped set aside a pool of money large enough for you to pay yourself a paycheck for the rest of your life when you reach retirement so that you can enjoy a comfortable retirement of life and leisure. If the 401(k) didn’t help set aside a pool of money large enough for you to do this, it wasn’t successful. What then does a 401(k) need from you to do this? Let’s take a look…

2. Working with your 401(k)

To grow and succeed in its intended purpose, a 401(k) needs regular “contributions” from you to fund it. Your employer will help you make this really simple. To fund your 401(k) your employer will help you by splitting up your paycheck on your behalf. Instead of all of your paycheck coming home to you, a portion will be sent to the 401(k), and the rest will come home to you. The 401(k) lingo for this is defined below:

Contribute [Kuhn-trib-yoot], verb – the act of funding one’s 401(k) by allocating deferred portions of one’s annual income to the 401(k).
Contributions [kon-truh-byoo-shuhns], noun – the deferred portions of one’s annual income allocated to fund one’s 401(k).
Defer [dih-fur], verb – to put off receipt of a portion of one’s annual income for the purpose of receiving a greater benefit from the forgone portion in the future.
Deferrals [dih-furuhls], noun – the deferred portions of one’s annual income.

Sample Useage: Saver Steve is participating in his 401k at 10%. This means he defers 10% of his annual income to contribute to his 401(k). His deferrals become his 401(k) contributions.

NOTE: It’s important to note that all of the money contributed to your 401(k) is still yours. Your employer is simply following your instructions on what to do with your money. If ever something comes up and you have to part ways with the company, for whatever reason, all of the money that you contributed, along with any earnings, and any portion of your employers’ contributions you’ve earned are all yours to take with you!

3. 401(k) & the Car: A Parallel

In a lot of ways, a 401(k) is like a car. In order for a car to take you somewhere, it needs to have gas (or fuel cells or electricity, but for simplicity we’ll stick with gas) in its tank. Your contributions are to a 401(k) what gasoline is to a car. Without contributions, a 401(k) cannot take you anywhere.

The question then is, how much ‘gas’ does a 401(k) need? Knowing the answer to this question and then having the discipline to commit to this may determine whether or not your 401(k) is ultimately successful. This can be a difficult question to answer, so first we’ll look at a General Rule, and then we’ll get more advanced.

4. The General Rule of 401(k)

The general rule of 401(k) is that you should contribute 10% of your annual income to the 401(k) for it to help in your retirement. To give an example, pretend Saver Steve receives $2,000 per paycheck before taking into consideration taxes. Following the general rule of 401(k), Saver Steve would contribute 10%, or $200 per paycheck to the 401(k).

Now this may seem like a lot of your annual income. Several of you probably feel like your wallet is light enough as is and that this isn’t something you can afford. It’s important to realize that contributing to your retirement is something you must do! If you didn’t marry rich, and you can’t picture the face of the person that is going to take care of you when you stop working, then look in a mirror. In order for you to enjoy a comfortable retirement of life and leisure, contribute to your 401(k) so it has enough gas to help take you where you want to go.

Remember that there are only two alternatives to a comfortable retirement of life and leisure, and neither is necessarily pleasant: working until you drop, or not being alive.

5. Advanced 401(k) Planning

The general rule of 401(k) is very broad. It is premised on research from several areas, taking into account many variables about age, employer matching, and giving a broad approach for mass use. As such, some of you may be looking for more depth on this topic. After all, being told to save 10% of your annual income may be a tough pill for some of you to swallow. To learn how to customize this rule to your own situation, or for more on why this is General Rule, continue to our Advanced Class, Class 201, “The Private Pension”.

6. Recap

The most important factor in determining the success of your 401(k) is your contribution to it. Remember, a 401(k) is like a car in many ways; it needs contributions like a car needs gas, and without ‘gas’, a 401(k) won’t take you anywhere!

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