Why Maxing Out Your 401(k) May Not Be Enough

An Ask Carrie reader recently wrote me to say she is turning 35 this year, and is finally ready to start saving for retirement. She wanted to know whether contributing the maximum to her 401(k) every year would be enough.  

I think this is a really important question, and I wanted to share my response with my LinkedIn readers, so here are three key points and my full response below:

Key Points

·      While contributing the yearly maximum to your 401(k) may seem like a lot, you need to crunch the numbers to see if it's enough for a secure retirement.

·      It's important to consider how much you'll want to spend in retirement, when you plan on retiring, how long you want your money to last, and how much you'll need in inflation-adjusted dollars to cover your costs.

·      Whatever your goal, get started right away. The longer you wait the more of your yearly salary you'll have to save.

First, congratulations to anyone getting ready to start saving for retirement. Making the first move can be the hardest of all, so I applaud your decision. My reader asks an excellent and often overlooked question. It’s understandable to assume that the government-allowed maximum 401(k) contribution (in 2018 it’s $18,500 for those under 50, or $24,500 for those 50 or older) would be sufficient—and often it is. The reality, though, is that there's no magic number that works for everyone. To get an individual assessment, you have to look a little deeper.

Start by thinking about how much you'll want to spend each year

With retirement 30-plus years out, this may seem like an impossible task. However, when you look at national statistics, it appears that on the average, retired households spend about 80 percent of what working households spend. This makes sense when you consider that some costs such as mortgage payments and work-related expenses may go down.

For example, when you are retired you’ll also no longer be subject to Medicare and Social Security FICA taxes. On the other hand, expenses such as travel, entertainment and healthcare may go up. So as a general guideline, I always recommend planning to spend just about the same amount in retirement that you’re spending now, less what you’ve been saving each year for retirement. That at least gives you something concrete to work with for planning purposes.

 Next, crunch your numbers

Let's start by assuming you're able to make the maximum yearly contribution of $18,500. Will that be enough? Here’s a way to do a quick estimate. 

Say that you’ll want to spend $80,000 a year in retirement and that you expect to receive $20,000 in Social Security benefits. Your portfolio will need to generate the $60,000 difference.

 An industry guideline commonly known as the “4 percent rule” states that you can safely withdraw 4 percent of your portfolio’s value in your first year of retirement, increase that amount every year for inflation, and have a 90 percent level of confidence that your money will last for thirty years. 

The corollary of this guideline is that your portfolio should be roughly 25 times larger than your first year’s withdrawal. In this example, $60,000 x 25 equals $1.5 million. That’s the amount you'll need to have saved on the day you retire. To get even more accurate, you should also consider the impact of inflation. That’s because in thirty years $1.5 million won’t have the same purchasing power that it has today.

Now pull out the financial calculator or use an online retirement calculator. For the sake of example, we'll assume an 8 percent return and 2 percent annual inflation. With these parameters, if you’re starting from zero and want to retire in 30 years (when you’re 65) with a $1.5 million inflation-adjusted portfolio, you’ll need to sock away about $22,500 a year. In other words, saving the government max of $18,500 leaves you a little shy of your goal. 

Be sure to add in any employer match

Here's where the value of an employer match can be significant. Many employers will match a portion of 401(k) contributions, in effect bumping up the yearly amount you save. For example, if you currently earn $80,000 a year, and your employer matches up to 5% of your salary, that could mean an additional $4,000 per year of savings. Add that to your personal contribution of $18,500, and you’re right on target.

Consider talking to an advisor

Of course your situation may be very different. You may want to retire earlier (or later), your rate of return may be different, and inflation may be higher or lower. However, this gives you an idea of how to come up with an estimate.

At some point, though, it would be a good idea to have an in-depth conversation with a financial advisor. He or she can talk to you about your expectations and priorities, run different scenarios, and craft a personalized plan that can incorporate other planning issues such as budgeting, risk management, and estate planning.

Don't delay

Starting to save for retirement at the age of 35, it's generally recommended that you sock away 15-20 percent of your yearly salary between you and your employer (thereby gradually increasing the amount you save as your wages increase) for the rest of your working years. If you wait, the percentage will go up accordingly. So no matter what, start contributing to your 401(k) right away.

And finally, if you can save beyond your 401(k) contributions, put those savings on automatic and consider a traditional IRA or Roth IRA account. That way, you’ll be less tempted to spend the extra money—and you'll have the satisfaction of knowing that you're paving the way for a financially secure retirement.

Here's my latest video on how to calculate your retirement needs:

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Have a personal finance question? Ask me in the comments. I can't respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.