Why Maxing Out Your 401(k) Isn't as Costly As You Think
Are you maxing out your pre-tax retirement plan, contributing $19,000 per year ($25,000 if over 50)? If not, you’ll be happy to find out that it doesn’t cost as much as you think.
How is this possible? 401(k) and 403(b) plans (two of the most common pre-tax workplace retirement plans) are pre-tax. You contribute money before income taxes are taken out, and you benefit from growth on your investments without having to pay taxes on gains until you start taking money out of the account in retirement.
The wonderful thing about pre-tax retirement contributions is the amount you contribute to these accounts is far more than the amount you see taken out of your take-home pay. There are some easy online calculators available that will estimate how much your tax-deferred contributions will affect your paycheck.
As an example, let’s consider Sally the saver. She makes $100,000 per year, a nice even number for calculating. Sally contributes 15% of her pay toward her workplace 401(k) plan, which she thinks is pretty good. $15,000 per year (or $1250 per month) is a significant amount of cash, after all!
What Sally may not realize is that her monthly $1,250 contributions do not actually reduce her monthly pay by $1,250. They only cost her $850, assuming a 25% federal tax rate and 7% state/local tax rate. In essence, Sally gets $1,250 in her retirement account at a 32% discount. Each dollar that she contributes toward her retirement only costs her 68 cents from her paycheck.
So the difference between maxing out her retirement plan and not maxing out her retirement plan is smaller—and more achievable—than it initially seems. The wonderful benefit of pre-tax accounts is that you get to fund your retirement with dollars that cost between 60-70 cents each, depending on your tax bracket.
Going back to Sally the saver: this means if she wants to contribute the maximum $19,000 (19%) of her salary toward retirement, it will only cost $12,924 from her take-home pay. Contributing 15%, on the other hand, costs $10,200. Wouldn’t you like to only pay $2,724 in exchange for $4000 in your retirement account?
The other enormous benefit of pre-tax accounts is tax-deferred growth. Not only are you getting a discount equivalent to your tax rate on every dollar you contribute, each of those dollars has the ability to grow and compound over time, without taxes dragging down returns. (Of course, taxes do need to be paid upon withdrawal, but not being taxed during the accumulation period is hugely beneficial).
The benefit of maxing out your retirement plan becomes even more obvious when you look at it visually. By maxing out, you’d become a millionaire 4 years earlier, and by the end of 30 years, you would have over $425,000 more.
If your employer matches part or all of your contributions, this is icing on the cake in terms of your account growth, but it does not count toward the $19,000 maximum contribution.
In all areas of your financial life, look for ways to stack the deck in your favor. Maxing out your retirement plan is just one way to do this. Look for the dollars that only cost you 60 cents!
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