If you think of your 401(k) plan in the context of how to leverage your retirement savings, think about 401(k) matching. Leverage makes your job as an investor ever so much easier, and what can be better than a company match?
Common Matches
The most frequent matching formula for Vanguard 401(k) plans that have matching contributions is 50% on the first 6% of pay, according to Vanguard’s “How America Saves 2023” report, which examined the saving behaviors of nearly 5 million 401(k) plan participants.
A match can be higher or lower. No matter the size, it’s not something to be ignored. It’s a way to invest for retirement using your employer’s money, not your own. (Matches are yours to take with you after you meet the plan’s vesting schedule.)
401(k) Math: An Easy Example
A previous post talked about the math of compounding, comparing three individuals aged 25, 35, and 45. To illustrate compounding in an easy example with identical contributions, they contributed $500 a month for the five years, for a total of $30,000, with no additional contributions after that.
They invested in the S&P 500 Index fund, which is a common 401(k) investment option.
Their age-65 results would be market-dependent. For a historical frame of reference, we’ll review the median historical S&P 500 Index holding period returns for the 45-year-old (20 year holding periods); the 35-year-old (30 year holding periods); and the 25-year-old (40 year holding periods).
401(k) Math: Leveraging Compounding Plus 50% Match
The three individuals participated in 401(k)s offering 50% matching — for each dollar they contributed, the company contributed 50 cents.
The 45-year-old with 20 years of compounding leveraged $30,000 into $192,ooo by age 65. The 50% company match brought the age 65 balance up to $288,000 ($192,000 + $96,000).
The 35-year-old had 30 years of compounding, giving this person $786,000 ($524,000 plus $262,000) at age 65.
And the 25-year-old had $2,400,000 ($1.6 million plus $800,000) at age 65.
Again, all three invested only $30,000. The only difference? Leverage — the leverage achieved through the math of compounding, leveraged further by the company match.
401(k) Math: Leveraging Compounding Plus 100% Match
What if the company match had been dollar-for-dollar?
With a dollar-for-dollar match, the 45-year-old’s balance at age 65 would be $384,000 ($192,000 times two); the 35-year-old’s would be a little over $1 million ($524,000 times two); and the 25-year-old’s would be $3.2 million ($1.6 million times two). Remember, we’re talking about pre-tax contributions of only $30,000. And, we’re leveraging the match and letting the math of compounding do its work.
Maximize That Match
It’s always a good idea to get every cent of matching funds. If your match is 50 cents on every dollar you contribute up to 6% of your pay, you’d have to have a very convincing reason to contribute anything less than 6% of your pay. With a 50% match, that’s a 50% return on your money once the match vests. A dollar-for-dollar match doubles your investment. Where else can you double your money so easily?
Pre-Tax Advantage
The pre-tax nature of 401(k) contributions also adds leverage. How? In this example, the $30,000 contributed pre-tax to the 401(k) was not taxed as income to you even though you earned that money. That means the taxes you would have paid lowered the “cost” of your contribution by the amount you saved in taxes.
Neither the 401(k) pre-tax contribution nor the matches count as taxable income on your W-2. When you make a pre-tax contribution, you’ll lower your W-2 income by that amount each year, which in turn will lower your income tax bill for the year (you can estimate the amount saved by multiplying the pre-tax contribution times your tax rate).
Rules To Live By
You owe it to yourself to leverage your 401(k) to make it easier to achieve your retirement savings goals. That’s the best way to take care of the future you with the least amount of effort. The most important rule to live by: Don’t waste compounding potential by waiting.
Not Participating In Your 401(k)?
If you are not participating in your 401(k) because you think you can’t afford to, let’s see if that’s really true. Take a few minutes to read my earlier post on the subject before deciding against contributing to your 401(k). If you have questions about how this might work for you, don’t hesitate to email me ([email protected]).
You & Your 401(k)
If you are a 401(k) participant who has done his or her homework, tell me your story. The 401(k) Champion competition is a pro bono educational initiative that I created, fund and sponsor in my role as a proponent of financial literacy. My goal is to encourage 401(k) participants to share their knowledge and enthusiasm through this national essay contest, with no cost to participate. One of the 2022 401(k) Champions, Kevin Alexander, put it this way in his essay: “I’ve received a lot of advice over the decades. . . . The best advice I ever received? Start a 401(k) and do it today.”
Questions
To keep up with topics that I cover, be sure to follow me on the forbes.com site (and if you would like to subscribe, check out the red box at the top right). Write to me at [email protected]. Include your city and state, and mention that you are a forbes.com reader. While all questions cannot be answered, each email is read and reviewed and can lead to discussion in a future post.
Disclosure: The author funds 100% of the costs of running the annual 401(k) Champion essay competition mentioned in this post as part of her firm’s pro bono mission to promote financial literacy education. Three yearly winners each receive $1,000.
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