Photo: Mindsay Mohan
When you sign up for your company’s 401(k) plan you need to decide how much of your paycheck to direct deposit into the retirement account. This seemingly simple decision could have an enormous impact on how prepared you are for retirement.Here are a few ways to select an appropriate 401(k) contribution rate.
Maximum allowable amount. Retirement savers can contribute up to $17,000 to their 401(k) account in 2012, up $500 from 2011. Investors age 50 and older can defer taxes on up to $22,500 because older workers are allowed to make catch-up contributions worth as much as $5,500. To completely max out your 401(k) and get the maximum possible tax break you will need to save about $1,417 per month, or $1,875 monthly if you are age 50 or older.
Matching level. If you can’t max out your 401(k), try to contribute enough to get the maximum possible 401(k) match. The most common 401(k) match formula is 50 cents for each dollar contributed up to 6 per cent of pay. Under this match formula, an employee earning $50,000 who saves $3,000 in the 401(k) plan will get another $1,500 from his or her employer as a matching contribution.
Default rate. Some 401(k) plans (42 per cent) automatically enroll new and sometimes existing employees in the 401(k) plan, according to a Plan Sponsor Council of America survey of 401(k) plans. When this happens, a default saving rate is selected for the employee. The most common default saving rate is 3 per cent of pay. Some 401(k) plans also automatically escalate the rate employees save over time unless they opt out.
Saver’s credit limit. Low income workers who save for retirement could aim to maximise the saver’s tax credit, which can be claimed on up to $2,000 ($4,000 for couples) that is contributed to a 401(k) or IRA. Retirement savers who have modified adjusted gross incomes of up to $28,750 ($57,500 for couples) in 2012 can get this nonrefundable tax credit that is worth up to $1,000 ($2,000 for couples).
A personal calculation. The ideal way to determine how much to save is to calculate the amount you will need to have by the time you retire to live comfortably. However, less than half (42 per cent) of current workers have even attempted to determine how much money will be necessary to cover their likely retirement expenses, according to an Employee Benefit Research Institute survey.
It can be difficult to calculate exactly how much money is necessary for retirement because you need to make certain assumptions, including your likely life expectancy and investment performance. Among workers who have done a calculation, a quarter determined they need to save over $1 million to retire comfortably.
Almost another quarter (24 per cent) think they can retire well on less than $250,000.
Professional recommendations. A financial adviser should be able to help you calculate how much you need to save each year to achieve your desired retirement lifestyle.
On average, 401(k) plan sponsors say employees should be saving 12 per cent of their pay including employer contributions over their entire working career in order to provide adequate income during retirement, according to a Principal Financial Group online survey conducted by Harris Interactive.
But many of the employers surveyed disagreed over what constitutes an adequate savings rate. Just over half (52 per cent) of 401(k) plan sponsors think employees should be saving between 6 and 10 per cent of their pay for retirement, while others say they should aim to save between 11 and 15 per cent of pay (22 per cent) or 16 per cent or more (14 per cent).
Just 13 per cent of 401(k) providers say saving 5 per cent or less of pay will be enough to finance a comfortable retirement. And only 4 per cent of the employers surveyed measure if their employees are on track to have adequate retirement income.
Do what you can. Another strategy is to start out saving a very small percentage of pay, such as 1 per cent, and increase it each time you get a raise. A portion of windfalls of cash such as bonuses, tax refunds, or gifts can also be redirected to your retirement account.
The EBRI survey found that 62 per cent of current workers say it is reasonably possible for them to save $25 more per week than they are currently saving for retirement.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.