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Should You Invest Dollars or Percentages?

119499471383482357percent.svg.medIn many employer sponsored plans such as a 401k, 403b, 457, or SIMPLE employees are generally given the option of deferring a fixed dollar amount or fixed percentage of their income. The question becomes which category to choose when initially enrolling in the plan and whether or not to change the original decision.

Generally, the wiser decision is to choose (or switch to) the fixed percentage. The reason is that by choosing a percentage, you really never have to worry about increasing your contributions. For example, an individual starts a job earning $50,000 annually and decides to contribute 10% annually to his retirement plan which is $5,000 per year.

Let’s assume that he gets a raise and the following year he is earning $55,000 annually. This amounts to $5,500 annually to his retirement plan. In other words, his contributions automatically increased along with his increase in income. Ideally, this person could have the percentage increased by 1% annually if the employer plan allows it. Think of this as a “forced savings” of raises and or COLA adjustments.

Let’s assume he chose to save a fixed amount and let’s keep it at $5,000 per year as in the previous example. For the first year, this is identical to what he would have saved under the fixed percentage. However, his contributions remain the same throughout his career unless he is diligent enough to change every time he gets a raise.

The good news is that he’s at least saving. The bad news is that over time, he’s saving the same amount even though his income may (and generally does) increase substantially over his working lifetime.

There is a benefit, however, of the fixed dollar amount. The maximum contribution that an individual can make to their 401k for 2015 is $18,000 annually and $24,000 if they’re age 50 or older. Let’s assume the individual wants to contribute the limit, but is concerned about going over if they choose a percentage. Let’s also assume the individual is paid 24 times per year. This amounts to a fixed dollar amount of $750 per paycheck (assuming he’s under age 50). This can of course be adjusted then whenever contribution limits increase.

Another example of where a fixed dollar amount works is when a person contributes monthly to their IRA. Unless contributing a lump sum, most IRA custodians allow a certain amount to be automatically withdrawn from a bank account into the IRA on a monthly basis. Here, an investor can save up to $458.33 if they’re under age 50 and $541.66 if they qualify for the catch-up contribution.

So an investor can really do both a fixed dollar amount for their IRA and fixed percentage to their employer sponsored plan should they so choose.

One Comment

  1. Dave says:

    Re: 401K contributions – All of the 401’s I’ve had implemented the IRS mandated limit to the $ amount you could contribute annually. Once you hit the limit, your contributions were automatically stopped. You *>couldn’t<* contribute more than the $18,000/$24,000 limit annually. Resulting in a nice take-home-pay bump towards the latter of the year. (And a sudden drop on the first of the year when the contributions kicked back in.) I would always aim at a 33% contribution… YMMV

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