Making use of your salary deferral agreement

When you enroll in a 401(k) plan, you fill out a salary deferral agreement. Salary deferral refers to the pre-tax amount of your pay that you want your employer to put in the 401(k) plan rather than in your paycheck. It probably also gives you the option to make after-tax Roth contributions.

The form may require you to select a percentage of salary to contribute, or it may ask for a dollar amount. In fact, it may even give you a choice, such as the one shown in Figure 12-1. What’s the difference? Take a look:

• The percentage of salary is easy because it’s the same no matter how many pay periods you have. If you want to contribute 10 percent of your pay, you simply list “10%” on the form.
• For a dollar amount, you need to figure out the total amount you want to contribute for the year and then divide it by the number of pay periods. Say you get paid twice a month. If you earn $50,000 and you want to put $3,000 a year into your 401(k), you list “6%” on the form. This will result in a $125 per pay deduction ($3,000 divided by 24 equals $125).

If you work irregular hours or earn variable pay such as overtime, bonuses, or commissions, contributing a percentage of pay means a variable amount is deducted each pay period.

Some employers won’t let you include overtime or other forms of non-base pay as compensation for the purposes of contributing to a 401(k). In this case, contributions may be based only on your base pay or something less than your total compensation.

The most important thing is to start contributing as soon as you’re eligible. Even if you only contribute 1 percent of your salary to begin with, it’s a start. After you’re in the habit of saving, it gets easier and easier. But if you put it off, it only gets harder.

Measuring your plan’s maximums

Your 401(k) plan isn’t allowed to let you contribute more than the federal limits discussed in the previous section, but it probably restricts you to less because there are other things that must be deducted from your pay including federal and state income taxes, local wage taxes, and Social Security. Your plan may also have a priority that will be followed due to other deductions for medical coverage, charitable donations, and so on. Your employer decides the pecking order for your 401(k) contributions.

Being highly paid means different rules

Under federal law, employers must test their 401(k) plans each year to ensure that no discrimination exists in favor of highly paid employees.

The key question is: How much do you have to earn to qualify as a highly compensated employee, or HCE? The rules are pretty tricky. If you earn less than $130,000 and you don't own more than 5 percent of your company (and you aren't related to, or married to, anyone who does), you aren’t highly compensated. If that’s the case for you, feel free to skip this section. Otherwise, keep reading — but do a few jumping jacks first to make sure that you’re fully alert.

Estimating what your budget can afford

Talking about how much you’re allowed to put into a retirement plan is fine, but what about how much you can afford to put in? If money is tight, you may be tempted to wait and start saving in a couple of years when you’re earning more or have less debt. The problem with that strategy is that the longer you wait to start saving, the harder it gets psychologically. You get used to spending the money you have. Also, by waiting to participate, you lose a lot of potential earnings.

The following example (also illustrated in Figure 12-2) shows how you can cheat yourself big-time by waiting just a few years to start saving.

Ken, Rasheed, and Lisa all earn $50,000 a year. They all decide to contribute 5 percent of their salary, or $2,500, to their 401(k) plans, but over different periods of time. Assuming that each has an average annual return (how much the money increases in value when it’s invested) of 8 percent, look at the surprising results:

• Ken waits eight years to begin saving. In years 9 through 30, he contributes a total of $55,000 to the plan ($2,500 × 22 years), and his account balance grows to $143,654. (The extra comes from his 8 percent return, which is reinvested in the account each year without being taxed.)
• Rasheed starts saving right away, but he stops after eight years. He contributes only $20,000 to the plan ($2,500 × 8 years), but because he started earlier, his money has more time to grow through the magic of compounding. He ends up with $149,794 — $6,000 more than Ken after 30 years.
• Lisa saves for the entire 30 years. She contributes only $20,000 more than Ken, in total (over the eight years when Ken doesn’t contribute), but her $75,000 contribution grows to $293,448 — twice that of Ken’s, because her money benefited from compounding for a longer period of time.

You can see that it pays to start saving early and to keep saving. In this example, each person is saving a little more than $200 per month. If that seems like too much for you now, consider contributing a smaller amount. Sometimes that’s the best way to get started. For example, consider saving $20 per week, or $1,040 a year.

If you’re contributing to a 401(k), you can save $20 while only reducing your take-home pay by about $16 per week, because you save the $20 before paying taxes if you opt for pre-tax contributions, while you get your take-home pay after paying taxes. Just about anyone who’s earning $50,000 can probably find a way to save $20 a week. If you keep a record of your nonessential spending for just one week, you may find that eliminating one or two things is easy. (In Chapter 11, I suggest ways to find money to save if you’re on a tight budget.)

Remember that even a small amount of savings makes a big difference over time. That $20 per week invested for 35 years with an 8 percent return can eventually become $180,000! Any employer matching contribution increases this amount (see Chapter 4 for more on employer matching).

After you start saving, make it a goal to increase your savings rate each year. Perhaps the easiest way to do this is to save more each time you get a raise. If you start by contributing 1 percent of your pay, and you receive a 4 percent pay increase, use part of the raise to increase your contribution rate to 2 percent. Keep doing this each time you get a raise, until you reach a point where your savings plus any employer contribution is likely to provide an adequate level of retirement income. (Check the guidelines in Chapter 11.)

If you’re retiring in the near future

Assume that you’re retiring at the end of this year, and your salary for this year is $50,000. According to my benchmark, you should save $500,000 to hit the 10-times goal.

Sound like a lot of money? It is, but it would provide approximately $30,000 a year of inflation-adjusted income (see the sidebar “What goes up — or inflation-adjusted income” in this chapter for more information) over 25 years, assuming

• The rate of inflation is 3 percent.
• Only a small cushion will remain at the end of 25 years.
• You invest 50 percent of your nest egg in stocks and 50 percent in bonds during this period.

A yearly income of $30,000 may not sound like much, but remember that your taxes will be lower when you retire, and you won’t need to save for retirement anymore. Your expenses will likely be less than when you were working. Your income should also be supplemented by your taxable savings and Social Security, giving you an adequate level of retirement income.

If your retirement is farther off

I can hear you calling, “Hey, a little help over here… I’m not retiring tomorrow, so how do I know how much I’ll be earning the year before I retire?” Not to worry. Table 12-1, Ted’s Inflation Adjustment Table, is here to help.

Assume that you’re 41, and you want to retire when you’re 62. You need to project your current income to what you think you’ll be earning 20 years from now (at age 61, the year before you retire). Decide on an average rate that you expect your income to increase — say 3 percent. Go down the Number of Years column in Table 12-1) to 20, and over to the 3% column, where you see the factor of 1.80. Multiply your current income, say $50,000, by 1.8, and you’ll see that your expected income at retirement is $90,000. Using the 10-times rule, your desired nest egg becomes $900,000 (10 × $90,000). This is an easy way to get a rough idea of how big a retirement account to build — regardless of your current age or income.

Using a retirement calculator

Another way to develop a workable retirement plan is by using one of the many retirement calculators and other tools available on the internet or through the financial organization that handles your money. Remember that each calculator uses different methods and makes different assumptions; so different calculators can produce widely varying results. Check the assumptions each calculator uses to see if they make sense for you and your situation.

The major benefit of using a retirement calculator is that it gives you an investment reality check. Will the amount you’re saving and the investment mix enable you to accumulate what you need? A good retirement calculator will answer this question and also help you decide how to close any savings gaps. Generally, you can close a gap by increasing your contributions, adjusting your investments to achieve a higher long-term return, or a combination of the two.

As of September 18, 2021, employers are required to inform each 401(k) participant of the value of the life annuity income that can be provided beginning at age 67 using the current account balance. Hopefully, participants will start receiving this information during 2022.

It would be even more helpful if the service providers would include other income projections such as how much monthly income you can expect assuming you continue to contribute your current contributions until age 67 or an even broader range of income projections. This type of assistance to help 401(k) participants plan for retirement is long overdue.

If your retirement plan is an IRA, you can use retirement income calculators available through many financial organizations and AARP.