Let’s say you make $75,000 per year and you are saving 10% in your 401(k). Now let’s say you get a 5% raise, which puts your new annual income at $78,750. Now, before you go make a budget based on your new income, I want you consider increasing your 401(k) contribution percentage by 1% to 11%. To see why, take a look at the graphic below, which shows three scenarios. The first column is the current income of $75,000 and a 10% contribution to the 401(k). The next two columns are at the new pay level. The second column shows what happens if the 401(k) contribution stays at 10% and the third column shows what happens if you raise it to 11%.
By raising the contribution percentage to 11%, you’ll accomplish:
1. Raising your contributions by $1,163 per year instead of just $375.
2. Your Federal income tax* will only go up $388 instead of $506.
3. You’ll still have a net income increase (after taxes AND 401(k) contributions of $2,200 over your previous income.
It’s amazing what a difference 1% makes. Sure, you could keep your contributions at the 10% level and still increase the dollar value of your contributions by $375 per year. But, by increasing the percentage amount by 1%, you’re taking advantage of the raise and bringing down your income tax liability and STILL bringing home close to $200 more per month. It’s a win-win situation.
That said, it’s VERY IMPORTANT that you make the changes to your 401(k) as soon as you find our about your raise. Otherwise, you run the risk of getting too comfortable (or dependent) with your new income and then it will be that much harder to increase your contribution percentage. That additional contribution amount could mean an additional $57,000 to your retirement plan in 25 years (assuming an 8% rate of return and not assuming future contribution increases).
This is how we build wealth.
* Based on 2010’s income tax brackets, standard deduction, exemptions, and the child tax credit (assuming a family of four).