The amount you should be contributing to your employer sponsored retirement plan depends on your current situation and changes as you make progress.
Employer Sponsored Retirement Plans
According to the Bureau of Labor Statistics, nearly 1 in 5 US workers who have access to an employer sponsored retirement plan does not participate.
Should the participation rate be 100%? You may think that I would say “yes.” But, the truth is that sometimes it is necessary to do some groundwork first, before it is beneficial to start putting money aside for retirement.
The rest of this article will lay out my thoughts on how to determine if you should be contributing to your employer sponsored retirement plan. And, if you should participate, how much should you contribute?
Let’s dive in.
Strong Foundation First
As I have written about before, raiding your retirement nest egg early has permanent, irreversible consequences.
The only unique benefit of retirement plans is the way they are taxed. And, that benefit goes away if you break the rules. So, I don’t think that you should start investing in your retirement plan until you are sure that you won’t have to break the rules and pull money out early.
That is why, in my 12-step plan to eliminate debt and build wealth, investing for retirement starts in step 6. There are a few things that I think should be true before you participate in your 401(k) or 403(b).
Not in an Emergency
If you are in a financial emergency, then you should be devoting all of your resources to getting out of that emergency. It does not make sense to invest in your retirement if your house is falling down around you. Emergencies can be things like car repairs, medical expenses, IRS debt, or home repairs.
No Ultra High-Interest Debt
I actually consider ultra high-interest debt a financial emergency. If any of your debts have an interest rate above 30%, then I would consider that a financial emergency and they need to be eliminated as fast as possible. These debts can be things like payday loans, title loans, instant cash personal loans. I have seen interest rates as high as 300% on these kinds of loans.
Starter Emergency Fund
After you have handled your emergencies, including ultra high-interest debt, then the next step is a starter emergency fund. A starter emergency fund is a money market or savings account set aside with enough on deposit to cover all of your household expenses for one month.
No High-Interest Debt
Then, after your starter emergency fund is complete, it is time to tackle your high-interest debt. These debts have interest rates between 10% and 30%, and they should be evicted from your life before you start investing for retirement.
Get Match from Employer Sponsored Retirement Plan
After you have completed all of the steps necessary to eliminate high-interest debt from your life, then you are ready to start contributing to your employer sponsored retirement plan.
One of the benefits that makes employer sponsored retirement plans unique is that sometimes your employer will add money to your account for you. In order to get these employer contributions, you usually have to participate in the plan and add your own money. Then, your employer will match some, or all, of your contributions, up to a certain percentage of your total income.
For example, let’s say you make $60,000, and your employer will match 100% of your contributions, up to 3% of your income. That means, if you put in $1,800 (3% of $60k), then they will also put $1,800 into your account.
Now that you have all of your debts with interest rates above 10% paid off, and a starter emergency fund, you should feel comfortable diverting a small percentage of your income into retirement, in order to get your employer match.
For most people, their monthly discretionary income actually goes up at this point. That is because the payments that were going to high-interest debt are often larger than the amount required to get the employer match. In our example, a contribution of $1,800 per year is $150 per month. But, the payments required to eliminate that high-interest debt were likely more than that.
By eliminating your high-interest debt, you can give yourself a raise and start contributing to your retirement accounts at the same time!
6-Month Emergency Fund
At this point, you have paid off your high-interest debt and are getting your employer match in your retirement account. Now, it is time to increase your emergency fund.
A 1-month emergency fund is not a good long-term solution. It is too small and should make you nervous, which will motivate you to continue through the steps. Before increasing your retirement contributions beyond what is necessary to get the match, you should have a full 6-month emergency fund.
Low Interest Non-Mortgage Debt
After your emergency fund has enough to cover your expenses for a full 6 months, it is time to eliminate the rest of your non-mortgage debt.
All non-mortgage debts should be paid off in this step. That means car loans, student loans, personal loans, and everything else. And, yes, that means paying off your 0% car loan.
Boost Contributions to 15% in Retirement Plans
Congratulations! At this point in your financial journey you have built a very strong foundation. You have no non-mortgage debt. Your emergency fund has enough to run your household for 6 months. And, you have already started building your nest egg, using your employer match.
Now, it is time to supercharge your wealth building. It is time to contribute 15% of your household income into a retirement plan.
In our example, that means increasing the contribution from $1,800, to $9,000 per year. And, when you consider the employer match of $1,800, that means almost $12,000 per is going into retirement each year. A family on this plan, starting at age 30, will have nearly $2.5 million in their account by age 65.
Employer Sponsored Retirement Plan vs Roth IRA
We need to take a quick sidebar for a point of clarification.
If you are only contributing enough toward retirement to get your employer match, then 100% of your contributions should be at work. Doubling your money, through the match, beats any small difference between Roth and Traditional IRAs. However, when you boost your contributions to 15%, you may want to do some of that extra outside your employer’s plan.
Basically, that means contributing enough to receive the match at work, then contributing the maximum to individual Roth IRAs. If that is not enough to get you to 15% of your income, then you can go back and increase your employer sponsored plan contributions.
Save for Kids College
At this point, you have all of your non-mortgage debt paid off, an emergency fund in place, and 15% of your income going into retirement. But, retirement isn’t the only financial goal you have.
Just like in an airplane safety demonstration, now that you have your own oxygen mask on, you can turn your attention to those around you. Now, it’s safe to start working on how your kids are going to get through college without drowning in debt.