You know the old saying.
There is no such thing as a free lunch.
Other than soup kitchens and catered corporate events.
Add 401k matches to the short list of exceptions to the rule. 401k matches are free lunches, free dinners, and free leftovers for breakfast the next day.
What is a 401k account?
Let’s start with the basics for those who have no clue what this 401k thing is. A 401k is a savings account provided by your employer. You put money in the account now and it grows for a long time and makes you filthy rich over time. Unless you withdraw the money and waste it on junk.
But wait, there’s more! The account is intended to fund your retirement. Our friends at the government think retirement is very important. You get a huge tax break when you have part of your paycheck deposited into your 401k. Let’s look at some simple numbers for our young make believe friend Donald to see what he will save in taxes.
Donald makes a reasonably good salary for a recent liberal arts grad. He landed a sweet job at a sweet salary of $30,000 per year. He decides to start contributing to his 401k because he doesn’t want to be broke when he gets really really old. He contributes a modest $100 per month into his 401k. That won’t eat into his taco and domestic beer budget too much (he’s 24). His contribution to the 401k certainly won’t take $100 per month out of his paycheck!
Donald is probably paying income tax at a rate of around 20% (assuming he is in a state that has income tax). Of every $100 of Donald’s earnings, $20 disappears to taxes and Donald only gets $80 of it.
Here is one of the myriad secret powers of the 401k. That $100 contribution only reduces Donald’s paycheck by $80. Why? The $100 contribution never has income tax taken out of it. If he would have taken the $100 of earnings as cash in his paycheck, the tax man gets $20 and he only keeps $80 (to spend on tacos). But Donald chose the path of good by contributing to his 401k, and he gets to keep all $100 in his 401k, and the tax man doesn’t get to touch the $100 at all.
What Donald has done here is pretty clever. He has figured out a way to invest $100 for only $80 out of his pocket today. That is $20 of free* money! But that isn’t the free lunch I am talking about in this post.
The Real Free Lunch…
Is the 401k match that most employees receive. If you aren’t getting the 401k match that your employer provides, then you are making one huge mistake. It is free money (in addition to the tax savings of contributing to a 401k).
Do you know whether you have a 401k match? US News and World Report says 91% of 401k plans have some form of employer match.
According to US News,
Employer contributions vary considerably by employer, with Vanguard alone administering 401(k)s with more than 200 different match formulas. Almost half (48 percent) of 401(k) plans require employees to contribute 6 percent of their pay to the 401(k) plan to capture the maximum possible 401(k) match. Other employers require workers to save between 3 and 5 percent of pay (37 percent) or at least 7 percent (11 percent) to get the entire match offered.
The exact match formula plays a role in how easy it is for employees to actually take advantage of company 401(k) contributions. The most common 401(k) match is 50 cents for each dollar contributed up to 6 percent of pay, and 24 percent of 401(k) plans use this match formula. Another 14 percent of 401(k) plans offer a multi-tier match formula such as $1 for each dollar saved on the first 3 percent of pay and 50 cents for every dollar contributed on the next 2 percent of pay. And 7 percent of plans cap the maximum amount of employer contributions workers can get.
Odds are you qualify for an employer match. Even Starbucks matches up to 4% of your salary according to a professional barista that writes for “Starbucks Faster” (eat, er, drink that! independent coffee shops).
Figure out immediately what your match is and how to get it.
Let’s revisit Donald and his free $20 he saved on taxes for contributing to his 401k each month. His employer, like Starbucks, also provides 4% of his salary as a 401k match. This is $100 per month on his $30,000 per year salary. When Donald contributes $100 each month, his employer puts in another $100.
And that is Donald’s free lunch. He contributes $100, his employer matches it. Donald now has $200 saved in his 401k at a cost of only $80 out of his paycheck!
A common objection is that $200 can’t buy a new iPad, let alone the yachts and private jets I intend to purchase when I am living the life of luxury in retirement. Think about the $200 per month on an annual basis. $2400 per year. Still not quite able to cover the yacht or jet price tag? Ok, leave the $2400 per year in your 401k and let it grow for 30 years. At a 10% rate of return, you will have $42,000.
Not quite enough for a nice yacht or jet, but you get the point. A tiny amount of savings today can lead to huge amounts of wealth in the future. Donald will never miss the $80 per month taken out of his paycheck. That’s a night out drinking with his buddies. Donald can tell them to BYOB and swing by his parent’s basement to sip Pabst’s in his sweet sweet bachelor pad.
Where to Put the Money In a 401k?
I’ll answer that in future posts. For now, it doesn’t matter. Put it into something to get the match and the tax savings. $200 in contributions that only cost $80 out of your paycheck equals a 150% return immediately.
If you are totally clueless about what to invest in and you are 20- or 30-something, look for something like S&P 500 Index or Total Market Index. Anyone can pick a fund that is based on your retirement date (like Vanguard’s Target Retirement 2050 fund). We will get you much more savvy about fund selection in a later post, don’t worry. Just get your match now!
Why Do I Care About 401k Matches?
According to the New York Times’ Bucks blog:
Of the two million 401(k) participants evaluated, 39 percent were not saving enough to receive their employer’s full matching contribution (or they weren’t saving at least 5 percent of salary in companies with no match), up from 33 percent in 2008. Younger workers are even more likely to give up the free cash: 47 percent of participants under age 40 did not save enough to receive the full match, compared with 53 percent of workers under the age of 30.
Around half the employees age 40 or younger do not take advantage of the full employer match in their 401k’s. They aren’t eating their free lunches. Don’t be one of those suckers! Take your 401k to the all-you-can-eat-buffet of the employer match.
* It is free money now, but you may have to pay tax on it later when you withdraw money from your 401k. Stick around and in a subsequent blog post I promise to reveal the secret of why you may never pay tax on the 401k withdrawals.
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