Retirement Contributions – Percentage of Pay vs Flat Dollar Amount
Enrolling in a company retirement plan is usually the first step employees take to join the plan and it is important that the enrollment process be straight forward. There should also be a contact, i.e. an advisor (wink wink), who can guide the employees through the process if needed. Even with the most efficient enrollment process, there is a lot of information employees must provide. Along with basic personal information, employees will typically select investments, determine how much they’d like to contribute, and document who their beneficiaries will be. This post will focus on one part of the contribution decision and hopefully make it easier when you are determining the appropriate way for you to save.
A common question you see on the investment commercials is “What’s Your Number”? Essentially asking how much do you need to save to meet your retirement goals. This post isn’t going to try and answer that. The purpose of this post is to help you decide whether contributing a flat dollar amount or a percentage of your compensation is the better way for you to save.
As we look at each method, it may seem like I favor the percentage of compensation because that is what I use for my personal retirement account but that doesn’t mean it is the answer for everyone. Using either method can get you to “Your Number” but there are some important considerations when making the choice for yourself.
Will You Increase Your Contribution As Your Salary Increases?
For most employees, as you start to earn more throughout your working career, you should probably save more as well. Not only will you have more money coming in to save but people typically start spending more as their income rises. It is difficult to change spending habits during retirement even if you do not have a paycheck anymore. Therefore, to have a similar quality of life during retirement as when you were working, the amount you are saving should increase.
By contributing a flat dollar, the only way to increase the amount you are saving is if you make the effort to change your deferral amount. If you do a percentage of compensation, the amount you save should automatically go up as you start to earn more without you having to do anything.
Below is an example of two people earning the same amount of money throughout their working career but one person keeps the same percentage of pay contribution and the other keeps the same flat dollar contribution. The percentage of pay person contributes 5% per year and starts at $1,500 at 25. The flat dollar person saves $2,000 per year starting at 25.
The percentage of pay person has almost $50,000 more in their account which may result in them being able to retire a full year or two earlier.
A lot of participants, especially those new to retirement plans, will choose the flat dollar amount because they know how much they are going to be contributing each pay period and how that will impact them financially. That may be useful in the beginning but may harm someone over the long term if changes aren’t made to the amount they are contributing. If you take the gross amount of your paycheck and multiply that amount by the percent you are thinking about contributing, that will give you close to, if not the exact, amount you will be contributing to the plan. You may also be able to request your payroll department to run a quick projection to show the net impact on your paycheck.
There are a lot of factors to take into consideration to determine how much you need to be saving to meet your retirement goals. Simply setting a percentage of pay and keeping it the same your entire working career may not get you all the way to your goal but it can at least help you save more.
Are You Maxing Out?
The IRS sets limits on how much you can contribute to retirement accounts each year and for most people who max out it is based on a dollar limit. For 2018, the most a person under the age of 50 can defer into a 401(k) plan is $18,500. If you plan to max out, the fixed dollar contribution may be easier to determine what you should contribute. If you are paid weekly, you would contribute approximately $355.76 per pay period throughout the year. If the IRS increases the limit in future years, you would increase the dollar amount each pay period accordingly.
A company match as it relates to retirement plans is when the company will contribute an amount to your retirement account as long as you are eligible and are contributing. The formula on how the match is calculated can be very different from plan to plan but it is typically calculated based on a dollar amount or a percentage of pay. The first “hurdle” to get over with a company match involved is to put in at least enough money out of your paycheck to receive the full match from the company. Below is an example of a dollar match and a percent of pay match to show how it relates to calculating how much you should contribute.
Dollar for Dollar Match Example
The company will match 100% of the first $1,000 you contribute to your plan. This means you will want to contribute at least $1,000 in the year to receive the full match from the company. Whether you prefer contributing a flat dollar amount or percentage of compensation, below is how you calculate what you should contribute per pay period.
Flat Dollar – if you are paid weekly, you will want to contribute at least $19.23 ($1,000 / 52 weeks = $19.23). Double that amount to $38.46 if you are paid bi-weekly.
Percentage of Pay – if you make $30,000 a year, you will want to contribute at least 3.33% ($1,000 / $30,000).
Percentage of Compensation Match Example
The company will match 100% of every dollar up to 3% of your compensation.
Flat Dollar – if you make $30,000 a year and are paid weekly, you will want to contribute at least $17.31 ($30,000 x 3% = $900 / 52 weeks = $17.31). Double that amount to $34.62 if you are paid bi-weekly.
Percentage of Pay – no matter how much you make, you will want to contribute at least 3%.
If the match is based on a percentage of pay, not only is it easier to determine what you should contribute by doing a percent of pay yourself, you also do not have to make changes to your contribution amount if your salary increases. If the match is up to 3% and you are contributing at least 3% as a percentage of pay, you know you should receive the full match no matter what your salary is.
If you do a flat dollar amount to get the 3% the first year, when your salary increases you will no longer be contributing 3%. For example, if I set up my contributions to contribute $900 a year, at a salary of $30,000 I am contributing 3% of my compensation (900 / 30,000) but at a salary of $35,000 I am only contributing 2.6% (900 / 35,000) and therefore not receiving the full match.
Note: Even though in these examples you are receiving the full match, it doesn’t mean it is always enough to meet your retirement goals, it is just a start.
In summary, either the flat dollar or percentage of pay can be effective in getting you to your retirement goal but knowing what that goal is and what you should be saving to get there is key.
Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally, professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, please feel free to join in on the discussion or contact me directly.