A client recently emailed me letting me know that she got a new job with a significant raise. She wanted help with selecting her employee benefits and said that she was going to contribute enough money to her 401(k) to make sure that she received the employer matching contribution, but she mentioned that she remembered that last year’s financial plan showed that she needed to contribute a higher percentage of her income, although it was at a much lower salary.
I’m not sure if this is what she was thinking or not, but the way that she worded it to me made me think that she believed she wouldn’t need to contribute as much of a % of her new income since she received such a large raise. If it is the case that she believed that, then I blame us for being poor teachers.
% Not $ Amount
Especially with a higher salary we would recommend that she contributes a higher % of her income to her 401(k). It’s actually even more important to contribute a higher percentage of her income than just contribute enough to receive the employer match now that her salary has increased. The reason for this is that when someone’s income increases, but they don’t increase their savings as well, they end up spending a lot more money and end up saving a much smaller % of their income. This is what we call lifestyle creep.
If you were to save a smaller percentage of a higher income, then the amount of money that you would be spending would increase disproportionately. I prefer to provide a % of income recommendation for clients to save based on their personal situations rather than a dollar amount to help make sure that their living expenses don’t increase too quickly as their pay increases. (There are other reasons to save a % of your income as well.)
For example, let’s assume she was earning $100,000 per year and contributing 10% of her income ($10,000) before her raise.
Now, let’s assume that her new job pays her $130,000 and the employer will match on up to 3% of contributions so that’s what she elects to contribute. Now she’s only contributing $3,900.
In order to contribute the $10,000 to her 401(k) that she was doing at her old job with a lower salary, she would only need to save 7.69% of her new salary.
So, there’s 2.31% of a $30,000 higher salary that’s being spent rather than being saved. It may not seem like a very large dollar amount, but it makes a huge difference over the course of 20-30 years when taking into consideration the effect of compounding, especially when also considering that her income is likely to increase each year.
It’s important to set your savings as a % of your income to make sure that you’re still saving an appropriate amount each year as your income increases to help set yourself up for a successful future.
