I read a post recently where someone said that even if you max out your 401k plan over your earning years, you wouldn’t have enough money to retire. Is that true? I hadn’t ever really considered the question before so I wasn’t sure. Rather than just take this person’s word for it, I did what any personal finance geek (and financial coach) would do – I ran the numbers.
How much can you contribute to your 401k plan?
For the year 2017 each person can contribute up to $18,000 to their 401k plan. Someone who is age 50 or older can contribute an additional $6,000 each year – for a total of $24,000.
This is per-person, so both members of a working couple can each contribute this maximum amount. That’s a total of $36,000 per year before age 50, or $48,000 per year from 50 onward.
Keep in mind it doesn’t cost you that much
That sounds like a lot of money doesn’t it?
Don’t forget that 401k contributions are pre-tax. So if you are in the 25% marginal tax bracket, that $18k only impacts your take-home pay by $13,500. Yes, the $4,500 you would have paid in taxes goes into the investment account and enjoys the power of compounding with all the rest of your money!
How about company matches?
Investopedia states that the average 401k company match averages to equal about 2.7% of a person’s income.
That in itself can have a tremendous impact on the growth of your investment account over an extended period of time!
But… not everyone gets a match. Additionally, different companies have different match policies. So rather than assuming everyone has the same benefit there, I’m going to exclude that amount from my calculations. If you’re getting a match at work – just know that you’ll have even more money at retirement.
What return might be reasonable in your 401k investments?
The point of this exercise is to determine if someone can contribute the maximum to their 401k over their entire earning years and have enough to retire. That being the case, what we care about is how the market tends to perform (has performed in the past) over most 40 year periods.
We can see from looking at this historical 40-year rolling return chart that the vast majority of 40-year periods produced average annual gains between 6% and 12%.
I looked at the background data and confirmed that every single 40-year period fell somewhere between 4.9% and 13.1%, with the average annual return over the period being 9.342%.
Don’t forget inflation
Inflation knocks off almost 3% from those returns though. So while you might get 9% average annual returns, the purchasing power at the end will feel more like a 6% return.