Outside the Box: How to make the most of your 401(k)

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Building a nest egg that can maintain your lifestyle and be financially independent throughout retirement is no small task. It requires savings, discipline, fiscal responsibility, sacrifice and smart decisions. Let’s talk about one of the really smart things you can do: make the most of your 401(k).

If your employer matches any portion of your 401(k) contributions, be sure to contribute at least enough to get that match.

Qualifying for employer 401(k) matches can literally be life-altering. Someone in their 30s or 40s who takes advantage of them can have hundreds of thousands of dollars more in savings when they retire.

Once you understand why this principle is so important, you’ll see how failing to take advantage of it is both shortsighted and, in many cases, downright foolish. Since we know you’re trying to be smart about living within your means, this is one you don’t want to overlook. In fact, if you need to choose between this and other uses of money — even paying off credit card debt (which is otherwise almost always the best use of money) — you’ll want to make sure that you get those employer matches.

Why is it such a big deal? After all, can’t you just take your salary and invest it yourself? Sure, you could, but the table below clearly shows why you shouldn’t. This table details what happens to $1,000 of salary if you do or don’t contribute it, assuming that it qualifies for your employer’s matching contribution (3% of salary is a common match amount):

The power of 401(k) matches
What you do with $1,000 salary A. Don’t contribute B. Contribute (and get employer match)
How that $1,000 is treated $1,000 is taxed as ordinary income $1,000 is deducted from salary and goes into 401(k)
How much goes to work for you, assuming a 24% marginal tax bracket: $760, which is invested in personal (taxable) accounts $1,000 is invested in 401(k) funds. This equals an immediate “return” of 32%, relative to the $760 you’d have left after paying taxes in column A.
Employer match $0 Another $1,000 is added by your employer, equal to an immediate return of 132% (on the $760 you’d have left after paying taxes in column A).
Total “return” (before any investments are purchased): 0% 164% ($2,000 vs. $760), all of which can compound without taxation until at least age 70½ (when RMDs begin)
Value in 20 years $2,432* ($3,040 minus 20% tax**) $8,000*
* Both columns assume a 7.2% rate of return, at which rate money doubles every 10 years
** Assumes 20% taxes at the end of 20 years. If investments turn over several times during those years, taxes would likely be considerably more than 20%.

Just look at that bottom row. Even with identical returns (in this case, I chose 7.2% because that happens to be a rate at which money doubles every 10 years), after 20 years you could have more than three times as much saved (in this example, your $1,000 of salary becomes $8,000 in 20 years, versus only $2,432 if you invest the same $1,000 after paying tax on it).

The key is that making 401(k) contributions (up to your employer match) puts far more money to work for you, and that means more money compounding for all of those years. So, what initially seems like a difference of just $240 ($760 vs. $1,000), really is a difference between $760 and $2,000, which is 164% more than $760.

Viewed another way, in order for $760 to grow to $2,000, you would need a compound rate of return (after taxes) of more than 10% a year for 10 years. And you get the entire $2,000 immediately (as soon as your employer makes that matching contribution), simply by saving $1,000 of salary to your 401(k) instead of paying taxes on it.

As great as that sounds, it is only a drop in the bucket, because the above deals with just one year’s contribution. Multiply the benefits of the table by decades of annual contributions, and the difference can be staggering and truly life-altering. Someone in their 30s or 40s could literally have hundreds of thousands of dollars more in savings when they retire than investing that same amount of salary after paying taxes on it each year.

No match? No problem

Should you make 401(k) contributions that are not matched by your employer? Yes. Although they won’t provide you as much immediate benefit, contributing the maximum amount permitted by your plan is still a good idea. That’s because:

a. As the third row of the table shows, you still get an instant benefit of 32%, relative to what you’d have left if you take $1,000 as taxable salary.

b. That extra 32%, as well as the rest of your $1,000, will be able to compound for decades without taxes. Yes, you’ll eventually have to pay taxes (when you take money out in retirement), but it’s like the government is giving you a loan, interest-free, that you get to compound for decades before having to pay it back.

c. In order to be financially independent in retirement, you need to be saving far more each year than what your employer will match, and your 401(k) is a great place to save more. Indeed, having the maximum allowable contribution deducted directly from your salary to fund your 401(k) makes it easier to be disciplined about living within your means.

d. Finally, you are much less likely to touch/spend money that has gone into a 401(k) or other tax-deferred account. If you take $1,000 as salary, and pay taxes on it, there is more temptation to spend some or all of that remaining $760 (assuming a 24% marginal tax bracket). If it has already gone into your 401(k), spending it would trigger taxes (and a 10% penalty if you’re under age 59½), so you’re much less likely to spend it.

For those in low tax brackets

If you are in the two lowest marginal federal tax brackets, 10% and 12%, there’s an important variation to the above. In 2019, you’re in the 10-12% bracket if your taxable income is less than $38,700 (filing single) or $77,400 (married filing jointly).

If you fit in this category, you should still contribute as much as you can to your 401(k), at least qualifying for employer matches, but you should direct that your contributions go into the Roth portion of your 401(k), assuming your plan offers that option (most plans now do). You won’t get the tax deduction, but your money will compound and grow tax-free (not just tax-deferred) for decades, and it can then be withdrawn tax-free during retirement. This makes the Roth 401(k) an outstanding place to build up your savings.

Financial independence during retirement requires having the discipline to put money in savings first, and forcing yourself to live on what’s left. But it also means being smart about how and where you save those dollars, and your 401(k) or other employer-sponsored plan—especially if there’s any matching involved—is one of the smartest ways to save.

Bruce Yates has been a fiduciary financial adviser for almost 35 years, and he is one of Viridian’s four founding shareholders. Viridian RIA LLC is an SEC Registered Investment Advisor (RIA) that offers financial planning, investment management, and tax services.

The preceding is partially excerpted from the upcoming book, “The Reluctant Investor”.