Want To Be A Millionaire? Increase Your 401(k) Contributions

By Matthew Frankel Markets Fool.com

Most 401(k) plans offered by employers have some sort of matching program. And, most participants contribute exactly enough to take full advantage of their employer's match, but not a penny more. While this is certainly a good start, it may not build enough of a nest egg to produce a comfortable, fulfilling retirement.

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With that in mind, you might be surprised at how much of a difference a small increase in your 401(k) contributions could make.

How much should you be saving in your 401(k)?

There's no perfect answer to this question, as it depends on several factors. At the absolute least, you should be saving enough to take full advantage of your employer's matching contributions -- so if they are willing to match your contributions up to 5% of your salary, that's the lowest amount you should be putting in, period. Anything less, and you're literally turning down free money.

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I generally suggest that 401(k) participants should aim to save 10% of their salary, not including any employer contributions. However, there are some exceptions. For example, if you also save money in an IRA, or have a pension plan in addition to your 401(k), you can probably do just fine with less than 10%.

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How much do you need to retire comfortably?

The better question is "how much income will I need, and how much savings will I need to sustainably generate this income?"

As a general rule of thumb, you can expect to need about 80% of your pre-retirement income after you retire. You can read a full discussion of how to determine your retirement number here, but here's a simplified version:

Social Security is designed to replace about 40% of the average worker's income, so the other 40% you need will have to come from other sources. If you don't have any pensions or other income sources, this means it will need to come from your retirement savings.

So, to get a ballpark estimate of how much you'll need in retirement accounts, follow these steps:

  1. Multiply your salary by 40% (0.4)
  2. According to the "4% rule" of retirement, you can safely expect to withdraw 4% of your retirement savings your first year of retirement, and then adjust for inflation in subsequent years. So, multiply the amount from step one by 25 (or divide by 4%).
  3. This is how much you'll need in savings.

You may be surprised at the difference a small increase could make

It may not sound like increasing your contribution rate by one percent of your salary could make a significant difference in your retirement savings over the long run, but you'd be wrong. You might be surprised to learn just how much of a difference a seemingly small increase could make. Here's a calculator that can illustrate the impact of increasing your 401(k) contributions could have.

* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.

A few things worth mentioning about the calculator. First, it's important to be realistic. Annual salary increases of 2%-3% throughout your career is probably a realistic expectation. 5% or more -- probably not. The same goes for your investment returns. I generally suggest that a properly allocated 401(k) can be reasonably expected to earn 7% annualized returns over the long run. If it earns more, great. I'm just saying not to expect it.

Next, "employer match" refers to the percent of your contributions your employer will match. For example, if your employer's matching program promises to match you dollar-for-dollar on contributions up to 5% of your salary, your employer match is 100%, since they're putting in the same amount of money you are. The "maximum employer match" is referring to the 5% limit.

An example -- how your 401(k) can make you a millionaire

Let's say that you're 35 years old, and plan to retire at age 65. You earn $50,000 per year, and your employer is willing to match your 401(k) contributions up to a maximum of 5% of your salary, and you already have $25,000 in your account. We'll assume that your investment returns average 7% per year, and that your salary increases by 2% per year throughout your career -- both pretty conservative estimates.

First, let's take a look at what could happen if you do what most people do and contribute just enough to get your full employer match -- 5% of your salary. In this case, you can expect your 401(k) to grow to about $830,000 when you're ready to retire.

Now, let's say that you increase your contribution rate by just one percentage point to 6% of your salary. This bumps your ending balance to nearly $893,000. And increasing your contributions further to 8% of your salary (still short of my 10% recommendation), you can reasonably expect to have more than a million dollars by the time you retire.

Check out the calculator, and think about how much you more you could afford to contribute, without making any major sacrifices to your lifestyle. You may be pleasantly surprised.

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