You may have read before that maxing out your Company provided Retirement Account is a good idea. It is actually a fantastic idea considering the amounts of money that the government and your company are willing to give you to participate.
But how good is that idea? Someone who maxes out its 401k could be making 65% as much in retirement as someone who doesn’t participate. Let’s put this on a few graphs to see what is the actual $ benefit of maxing out your contributions.
Why a retirement account is so great
Basically because there is so much money to be made with such little effort, it’s the best tool to become a millionaire.
Public pensions are broke so the government would really like to see individuals save up for their retirement. Companies are willing to move from defined-benefits to defined-contributions plans as quickly as possible to limit their future liabilities.
The tax-payer is then looking at 3 nice benefits:
- pre-tax contributions : this is FREE money from the government, ie. 0% tax on that portion of your salary!
- employer match: this is FREE money from your company, on average about 3% of pay,
- deferred tax: the government is being nice and will let your investment grow tax free until you reach retirement age. This is particularly useful for dividend growth.
The only requirement is that the funds need to be locked in the account until you reach 59.5 years. They can then be withdrawn without penalty and the benefits will be taxed at your then current tax bracket. The expectation being that once you retire you receive no more income, your withdrawals will be taxed with the lowest tax brackets.
Q : But if the money is locked in there for 30 years, why should I max-out that account?
A : Because all this ‘free-money’ adds up to a lot. And the effort required is close to 0.
Let’s take an example of Tim making 100k$ a year gross income, living in a state like Texas with no state tax. All expenses combined, he spends 55k$ a year. His company provides a slightly above average company match of 3%.
In our 1st scenario, he does not contribute to his employer’s 401k. In the 2nd scenario, Tim contributes 3% of his pay to match the amount his company will match. In the 3rd scenario, Tim maxes-out his contribution to 18k$, the maximum allowed this year.
We see on this graph that the benefits of contributing to the 401k plan far outweighs the ‘cost’ of the contribution. In fact, maxing-out equals a 50% increase of wealth compared to not contributing.
The combined incentives from the government and the company amount to 7,780$ a year.
That’s a 14.25% return on investment before market returns!
Who would say no to that?
Wealth benefits of a maxed-out 401k during 30 years
At the end of the first year, the benefits that have applied are the pre-tax contributions and the employer match. For the 3rd benefit to kick-in, the deferred tax, you need to look at a much longer time period. As you know, those things tend to benefit from compounding interests.
Let’s say that Tim has a very stable life: his earnings, his spend and his company match won’t change for the next 30 years until he retires. How would each of those 3 scenarios play out?
Tim’s investments are 100% equities in an S&P500 index fund. The expected long-term yearly growth is 6% + 2% dividend payout In a tax-sheltered account like the 401k, no tax will apply to the dividends. In a taxable account, the dividend tax is 15%, thereby reducing the actual dividend yield to 1.7%.
After 30 years of compounding interest, the maxed-out scenario ends up with 65% more wealth than the non contributing scenario.
What does it mean for your retirement income
I can hear a question coming from the back, asking for more personal information. Let me re-phrase it:
Q : So hey, I like your graphs, but even without contributions the guy ends up pretty well off, no?
A : Thanks for the compliment, but really this guy will not be able to sustain his lifestyle unless he maxes-out.
If we apply the 4% rule to the resulting wealth accumulated in all 3 scenarios, we note that a maxed-out contribution will provide an income comparable to his working years, or 65% more than what a plan with no contribution will provide. That’s an additional 42k$/year. Who wouldn’t take that?
Everyone should be encouraged to max-out their 401k accounts.
Note that with a 401k, you need to properly schedule your contribution throughout the year to fully benefit from the company contribution. Once the maximum contribution is reached, you can’t receive the company match anymore.
- If your employer provides a 401k, subscribe to it for automatic contributions, otherwise open an IRA.
- If your employer provides a match, contribute at least the minimum amount to get the match.
- Once you have managed the drop of cashflow, and adjusted your spending if necessary, max-out your contribution!
- Do not ever touch that money before it can be withdrawn penalty-free when you are ready to retire.
If you do not, please share what is your motivation in the comments section.
Nick – MoneyMiner
PS: The name of the 401k plan is actually a reference to the Internal Revenue Code section 401(k) enacted in 1978 to allow tax payers a break on taxes on deferred income. Two years later in 1980, a smart man discovered the obscure section and initiated the first 401k company-provided retirement account. More details on Wikipedia. And if you’re really really curious, you can see the actual text from Cornell University’s website here.