401(K) Matching
What does 401K matching mean?
When an employer offers 401k matching, they are guaranteeing that they will match a certain percentage of your contributions. A common match is 50 cents on the dollar. That means if you put one dollar into your 401k plan, they will match your contribution by putting 50 cents in. You just made 50% on your investment!
Why does contributing to your 401K till your company match make sense?
Let’s take a simple example. Suppose your annual family income is 75,000 USD and your company matches 50 cents on a dollar till a max of 4% of your income. In simple terms in a year if you contribute 3000 dollars (i.e. 4%) from your salary, they will contribute an additional 1500 dollars.
Let’s consider the following scenarios,
If you had not contributed to the plan
| Income | 3000 |
| Taxes | - 750 (considering a 25% tax rate) |
| Money in Hand | 2250 |
If you had contributed to the plan and withdrawn the money immediately
| Income | 3000 |
| Company match | 1500 |
| Fee for early withdrawal of money | - 450 (considering a 10% penalty) |
| Taxes | - 1012.5 (considering a 25% tax rate) |
| Money in Hand | 3037.5 |
Effectively by contributing to the 401K till the company match and withdrawing it immediately results in a 35% profit. If you were to invest the money in a growth instrument with this rate of return your money would double every 2 years.
Now let’s take it a step further. What if you were to not withdraw the money from your 401K till your retirement and consider that you retire in 30 years. Consider the average rate of return from your 401K to be 8%.
With matching contributions at retirement
Using the calculator at http://www.wealthbuildinglessons.com/calculators/compound-interest/ we see the following numbers,
| Contributions | 4500 |
| Rate of return | 8% |
| Number of years | 30 |
| Total Money | 600, 000 USD |
| After taxes | 450, 000 USD |
If you were to not contribute to the 401K but invest the money yourself, you would get the following numbers,
| Contributions | 4500 |
| Rate of return | 8% |
| Number of years | 30 |
| Total Money | 297,919.18 USD |
I haven’t even considered the taxes that you have paid on the profits made. Looking at the numbers it makes total sense to contribute to your 401K till the company match.
Should you contribute more than the company match to your 401K?
Depends on whether you are good at investing. If you are not good with finances I would suggest that you contribute the annual maximum of 15,500.
However if you are good with finances then you should invest the money somewhere else, where you can get a better return.
What do I do?
I obviously contribute as much as my company matches. I believe that there are far better places to invest the rest of the money and you can beat the mutual fund managers at that. I plan to write a detailed post on why I think so. With the dollar going down I feel that the place to invest money is in real estate investment in India since the stock prices over there have already gone through the roof.
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January 7th, 2008 at 2:01 am
if you can afford it, maxing out 401k contributions is a good way to reduce your taxable income.
but roth’s should be looked at, especially if you are young and in a low tax bracket.
April 16th, 2008 at 5:14 am
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