THE SUPER SIMPLE 401K GUIDE (Part 3): How much should you put in, retiring with $2 million, and how to avoid the next financial crisis

13 min readFeb 6, 2020

In Part 1 we learned where NOT to put your money, and in Part 2 we learned how to choose the right 401k fund.Now comes the all important question of how much money is the right amount to put into your 401k.

If you haven’t read parts 1 and 2 I highly recommend you start with them first:

(Part 1): Wall Street schemes, expense ratios, and avoiding 401k scams

(Part 2): Index funds, Blockbuster vs Netflix, and choosing your 401K

In Part 3 we’ll go over:

How much money you should put into your 401k
How employer matching works
How to choose between stocks vs bonds
What happens if you withdraw money from your 401k early

Let’s jump right in…

Bad Advice and the Starving Tech Worker

Bad advice you’ll hear about your 401k:

“The earlier you start the better.”
“You should put any extra money you have into your 401k.”
“Securing a retirement is the most important thing you can do for yourself.”

The amount of money you put into your 401k is dependent on a lot of factors, which we’ll go over below. Two common issues that I’ve seen though are people who take an all or nothing approach.

The first time I put money into my 401k was a few years ago when I was working at a tech company. I had a coworker, Elliott, who was a bit more junior than me.

Elliott was 25 years old and was always complaining about how he doesn’t have enough money, sometimes even skipping lunch because he had run out of money.

I thought this was really strange. Even though he was in a junior position, I knew that he was being paid very well.

One day I decided to approach him on the topic. “How are you always running out of money? Do you have an expensive girlfriend we don’t know about?” I asked jokingly.

Elliott laughed. “No, I wish! I’m just putting 40% of my paycheck into my 401k…”

My jaw dropped. I knew that there was no way I could put 40% of my paycheck into my 401k so I couldn’t even imagine how he was surviving on just 60% of an even smaller salary…in San Francisco of all places.

The 5 Criteria to Determine How Much to Put into your 401K

Your 401k should be something that provides you security not stress. If you’ve never put money into your 401k, don’t worry about it, I hadn’t put in a dime until I was 28 years old.

This wasn’t because I didn’t have the money.

When I was young I preferred to spend my money on experiences and travel, which I still believe is the best investment you can make in your early twenties.

“Travelling to Italy when you’re 20 will change you more than travelling to Italy when you’re 40. Italy won’t have changed in that time, but you will have.” — My Mom

The correct amount to invest in your 401K should be determined by five factors (in this order of priority):

Your income
Your debt
Your savings
Your employer matching
Your age

Income

The biggest determinant in how much you should put into your 401k is your income. Before you can consider putting money into your 401K, you need to be making more money than you’re spending.

Debt

Debt comes in two forms: low-interest and high-interest. The magic number when it comes to interest is 8%. If you have student loan debt (usually 5–6% interest), then you want to put your extra money into your 401k instead of into your debt.

Why? It’s as simple as a 2nd grade math problem.

Because the S&P500 reliably provides 9–10% returns, you’ll actually make more money from your 401k than your student loans will cost you in interest.

If, however, you have credit card debt (usually 10–25% interest), then you want to pay off that debt before you put a single dollar into your 401k. If you can’t pay off the credit card debt with your income alone, then I would even suggest taking money out of your 401k to pay it off.

When you take money out of your 401k they will charge you a 10% fee to withdraw the money early. That seems like a high penalty, but it’s actually way less than the 25% that your credit card company is charging you.

Again, pay off all your credit card debt before you put any money into your 401k.

Savings

Since you can’t take money out of your 401k without getting charged a 10% penalty, it’s best to only put money into it that is in addition to your savings. If you don’t have any savings, you can still use a 401k to get “free money,” which we’ll cover in the employer matching section below.

A common problem that people make is that they actually save too much. A couple of years ago, I attended a personal finance workshop hosted by a fiduciary.

Side Note: A fiduciary is someone who is legally obligated to give you advice that only benefits you. If your financial adviser is not certified as a fiduciary they aren’t legally obligated to have your best interests at heart. That means they can advise you to buy their high cost funds even if it’s not the best option for you and they won’t get in trouble for it.

The fiduciary had a very simple rule of thumb for savings that I thought was incredibly elegant. He said:

“You should only save 3 months of your living expenses and anything over that should go into investments or your 401k. If you want to be super conservative, you can save up to 6 months of expenses, but no more.”

The reason that you don’t want to save up more than that is because you’ll actually start losing significant amounts of money due to inflation. Inflation is an invisible force that doesn’t actually leave your bank account, which is why most people hold onto too much savings without realizing they’re losing money.

Let’s do a simple calculation:

Imagine you’ve saved $50,000 and are holding it in the bank. How much money would you guess you’re losing every single month to inflation?

a) $22
b) $42
c) $57
d) $73

*Answer at the bottom of this section.

Once you have 3–6 months of savings, the rest of your money should be going into your 401k. If you can’t manage to save 3–6 months of living expenses, then you need to either increase your income or decrease your expenses.

One of the best ways to decrease your expenses is by setting up a system that automatically withdraws money from your paycheck before it even arrives into your bank account. This technique has been the only one that has actually helped me spend less and I highly recommend it.

Ramit Sethi has a great post on the psychology behind why this works and how to set it up here, which I HIGHLY recommend as additional reading. Here’s a quick preview of his system:

Answer: If you guessed you would lose $73 per month, you’re right. Even with our currently small inflation rate of 1.76%, you would be losing $881 per year just by holding your money in your bank account. Even if your savings account gave you 1% interest back, you would still be losing money.

Employer Matching

Employer matching is only available for certain 401k plans. If your employer doesn’t offer employer matching, skip this section, everything else is still applicable though.

If your company offers employer matching that means they’ll put in the same amount of money into your 401k that you put in. Of course, they put limits on this, but the golden rule is that you should always max out your employer matching benefit.

Let’s take a fairly common example:

“ACME company will match 100% of your contributions up to 2% of your base salary.”

What this means: Your company will put in as much money into your 401k as you put in. Once you put in more than 2% of your salary, however, they won’t put in any more.

For simplicity, let’s say your salary is $100,000. If you put in $2,000 into your 401k, your company will throw in an additional $2,000. This means that you’ll have a total of $4,000 in your 401k even though you only put in half of that.

Employers do this to encourage you to use your 401k plan.

This resets every year, so essentially every year you can get an extra $2,000 from your employer for free.

Depending on what your employer matching policy is these numbers will vary, but the important thing is to always max out your employer matching as long as you can still fulfill the income, debt, and savings recommendations we already talked about.

Pro Tip: If you don’t have savings, but you just want to artificially increase your salary, you can use employer matching to offset the 10% penalty of withdrawing your money early. In the example above, you put in $2,000 and your employer put in $2,000. If you withdraw early you’ll get hit with a $400 penalty (10%), but you’ll still get to keep $3,600. That means you got $1600 for free. If you haven no intention of growing a 401k at the moment, you can still use this technique to just earn a little extra money from your employer.

Age

Your age is an important factor in how much you put into your 401k in a few ways.

The power of a 401k is time.

Without time, a 401k is just an inconvenient savings account. So, you’ll want to adjust your 401k contributions according to how much time you have before retirement.

A good recommendation is front loading.

Front loading — When you put more money into your 401k when you’re young and less when you’re older.

The reason that front loading your 401k works well is because your money gets multiplied by more years.

Let’s take two hypothetical people as examples: Jake and Sarah. Both Jake and Sarah will only contribute $50,000 into their 401ks and then stop adding more money:

Sarah knows what she wants to do early in life and gets a great job right out of college. She saves up 3 months of expenses, and then puts any extra money into her 401k. By age 28 she has put in $50,000, but then she starts a family and prefers to be with her kids rather than work. She doesn’t put anymore money into her 401k and just leaves it alone.
Jake doesn’t quite know what he wants to do with his life. He spends his twenties traveling the world and has some incredible experiences. In his mid-thirties, he finds the girl of his dreams and settles down. He gets a good job and puts $50,000 into his 401k by age 39. His family moves to San Francisco and they decide to put their kids into private school so he doesn’t have any extra money to put into his 401k. He leaves the $50,000 in there and just leaves it alone.

Both Jake and Sarah retire at age 70. Let’s take a look at their retirement accounts which both invested in the exact same 401k.

Even though both Jake and Sarah contributed the exact same amount into their 401ks, Sarah has $1.3 million dollars more than Jake. This is because her $50,000 was multiplied by an extra 11 years of compounding interest, dividends, and stock market growth.

This is why front-loading is highly recommended and why people will say, “the earlier you start the better.”

While this is objectively true, I still maintain that sometimes spending money on the right experiences is better than having a bit more money when you’re 70 years old. Finding that balance between enjoying your 20’s and enjoying your 70’s is a very personal choice you’ll need to make.

A common misconception about 401ks, however, is that you need to contribute to them your whole life.

This simply isn’t true.

With front-loading, you can buckle down to contribute $50,000 at an early age and then stop. You’ll still end up with a two million dollar retirement.

If, on the other hand, you’re in your 40’s or 50’s, you should still put money into your 401k, but you should expect to have more modest returns. In addition to your 401k, it may be good to also look into changing jobs, which can increase your salary by $40,000 and help boost your retirement savings way more than a 401k.

What if you’re 60 years old and already have a 401k

In Part 2 we covered how some people “lost” their retirements in the 2008 crash. There are two reasons why this happened:

They panicked and sold their stocks during the crisis
They had to retire at that time and couldn’t wait any longer

The first reason is fairly easy to overcome: DON’T sell your shares when the stock market crashes.

As Michael, the professional broker now marine, taught me in Part 1, “put your money in an index fund and don’t mess with it.”

If you leave your money in an index fund that follows the S&P500 it will always come back in value eventually.

But, what if you’re age 60 and you think that the economy might crash soon right before you want to retire?

This is where bonds come into play and it’s the only time you should mess with your 401k.

How Bonds work and when to use them

Bond: A bond is when you loan the government some of your money and they pay you back at a predetermined time in the future with a little interest added on.

Particularly in the United States, bonds are a great way to grow your money in a guaranteed way. While the stock market can fluctuate dramatically, bonds are guaranteed by the U.S. government and always give you back the exact amount they said they would.

In order to make this guarantee possible, the U.S. government sets it’s bond returns a bit lower than the stock market.

On average the S&P500 returns 9–10%, while U.S. bonds return 6%.

Bonds reduce risk, but also reduce returns.

So, how should we use bonds for our 401k?

As we near retirement, it’s good to start transferring our 401k from a stock-based fund to a bond-based fund. Here is an example of what this could look like:

Moving your money from stocks to bonds helps you lock in your savings so that they won’t be affected by a stock market crash. If the economy is doing incredibly well, we can move our money into bonds at a slower pace. If a recession is predicted to hit soon, we should move our money into bonds at a quicker pace.

As we discussed in Part 2, if you’re age 63 and you want to retire at age 65, it’s extremely risky to have a 401k fund that is made up of 100% stocks.

If the stock market crashes before you retire, your 401k will lose a ton of money and either you’ll have to accept the loss or you’ll have to wait until the stock market returns back to it’s previous levels. This usually takes between 5–10 years, which will delay your retirement to age 68–73.

That’s all for the essentials to setting up a good 401k. If you missed Part 1 or Part 2 I highly recommend you read them as well. If you’d like to learn about some interesting things you can do with your 401k, such as pay for a house or cash out early, you can read the bonus chapter here.