Do you want to work for the rest of your life to pay your bills? Thanks to the industrial revolution, worker rights, and the spread of global capitalism, you probably have the option to retire someday. Previous generations might have expected to work for the same company for thirty or forty years to retire with a pension. Times have changed; today's workers are even more responsible for their financial future than ever before.
Fortunately you have more options than ever before.
What is a 401(k)?
If you're a working professional in the United States, you likely have access to an employer-sponsored retirement plan known as a 401(k). A 401(k) is a special type of investment account which lets you invest part of each paycheck before you pay taxes on the money until you reach the age of retirement. While there are ways to invest post-tax dollars in a 401(k), check with a tax advisor on the mechanisms and implications.
Federal employees in the US have access to a different savings mechanism, and a new type of savings account known as the MyRA program is now available for other types of employees.
Contributing to your own retirement account can be a great deal:
- You'll set aside money now to have in the future.
- You'll pay fewer dollars in taxes right now, giving you a more to invest.
- You'll take advantage of compounding interest, through growth and dividends, to multiply your money over decades.
- You'll improve your financial self discipline, by paying yourself first.
Who Makes 401k Contributions?
The money in your 401k comes directly from your paycheck. Suppose you make $5,000 every month. If you set aside 10% of that—$500 a month—you'll contribute $6,000 into your account every year. If you do that every year for 30 years and see a decent average 8% return, you'll have over $700,000 from an investment of $180,000. After 40 years, you'll have over $1.6 million dollars from an investment of less than a quarter million dollars. Nice work!
Making a monthly contribution can be less painful than it seems at first. $500 a month may seem like a lot of money, but remember that it comes out of your paycheck before you pay taxes. If you assume a total tax burden of 25% (between state and federal taxes), that $500 contribution will shrink your actual paycheck by about $375, because you'd pay $125 in taxes if you took the entire $500 lump sum. That lessens the sting a little bit.
There are things you could do with $375 right now, every month, but it's to everyone's advantage for you to invest that money for 10, 20, 40 years instead. It's to everyone's advantage that you can avoid taxes and invest the entire $500 right now, which is why the taxes are deferred.
What is tax deferral? All of the dividends and growth you receive in this account gets reinvested. Instead of paying capital gains at every point you receive a dividend or make a profit on a sale, the 401k rules allow you to avoid paying taxes until that money has compounded over a period of (hopefully) decades: when you start taking money out of the account (age 59 and a half at the earliest and age 70 and a half at the latest). This means you get to invest that money now and let it grow, tax free, for decades.
What is a Company/Employer 401(k) Match?
Some employers contribute to your 401(k) as well. Why would an employer do this? Some employers are just that nice. Sometimes they see an advantage beyond kindness; some employers attach a vesting period to their contributions to retain talented employees. The longer you remain with the company, the more of that contribution you can keep. If you leave before the vesting period ends, you'll forfeit part of it.
Another benefit is more socially minded; by offering matching contributions, the company hopes to encourage its employees to invest in their own retirements. This is a tremendous advantage to you.
A final reason to encourage employee contributions is that the IRS limits the amount of contributions by "highly-compensated employees" based on the amount of contributions of "non-highly compensated employees". In other words, if average employees aren't saving very much, managers and top employees making six-figure salaries have limits on their available contributions. Encouraging everyone to invest at least a minimum amount allows the highest paid employees to contribute more to their own funds. (The details get very technical quickly, but at least the IRS rules encourage positive behaviors for both types of workers.)
How does 401k Matching Work?
Here's the best part of an employer contribution. Suppose your employer match is 5% of your salary. If you contribute 1% of your salary—$50 a month‐your employer will also contribute $50 a month to your 401(k). You defer taxes on both contributions. You'll end up investing $100 that month, leaving it to grow for (hopefully) a few decades.
If you invest 2% a month, you'll contribute $100 and get a match of $100. Your monthly contribution is $200. That continues up to the limit of the 5% match—$250—every month. The $250 pre-tax money you put in turns into $500 investment.
By taking advantage of the full amount of employer match, you earned a 100% return on your investment. You've doubled your contribution with no extra work on your part. You doubled your money immediately, tax free, at no cost to you. Try to find a deal that good anywhere else.
Of course, if you invest 10%—$500—you'll only get an employer match of 5%—$250—but it's still free money that will grow and compound. That $6,000 you contribute annually becomes an effective $9,000, so the $180,000 you personally contributed invest will produce over $1.1 million in 30 years and $2.5 million in 40 years. That's better than $700,000 and $1.6 million, and you didn't have to lift a finger to get it.
How Much Do Employers Match in 401k Contributions?
An employer could, in theory, match your entire 401k contribution, some $18,500 a year. In practice, it depends on the budget and the resources of the company and how much revenue came in that year. 3% is good. 5% or 6% is great. In any event, any matching is free money for you.
Should You Always Accept Employer Matching Funds?
Yes. Always accept your 401k company match as much as possible.
Unless you absolutely need every penny of your post-tax income to survive, investing enough to get employer matching is one of the best investments you can make. You double your money immediately and you won't pay taxes on that 100% gain. $1000 invested at 8% will become $1080 in a year. With an employer match for that $1000, your $1000 becomes $2160 at the end of the year.
Should You Contribute More than Your Matching Percentage?
Does it make sense to contribute more to your 401(k) than your employer match? Sometimes, yes. You won't double your money when you exceed your matching contribution, but the more you invest, the more you receive in return. If your cash flow situation lets you sock away a little bit more from every paycheck, you can take advantage of compounding and tax deferral for longer.
You need money to live on (and to enjoy life, perhaps by taking someone special out for a nice dinner or enjoying a vacation or buying something nice for yourself. You also need savings to help you weather life's ups and downs. Yet all 401(k) contributions come from pre-tax dollars, so you're investing more money than you'd miss from your paycheck. That decision depends on your financial situation.
401(k) contribution is a good idea; the incentives often align. When you account for employer matching, this can be a great investment vehicle. All that's left is deciding what to invest in in your 401(k). For more details, see Should You Invest In ETFs.
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