“Save for retirement.” I’ve heard this advice since I was 12. It is obviously a good idea. No one wants to be destitute in retirement and no one should count on much from Social Security. The problem with saving for the future is that you also want money now. The Frankly vision is not to work work work work work…...RETIRE! Our goal is to take plenty of time to enjoy our family while we are young and the kids are young. We save money in multiple ways for multiple goals.
A comfortable, more like fun, retirement (a recliner is comfortable but that's not our jam) is, of course one, of our goals. But, we also want to fund our adventures now. Taking advantage of our employer sponsored 401(k)s actually gives us more money now (and then). How? First by taking free money from our employers and second by sheltering money from the man. Other types of retirement accounts provide similar tax sheltering opportunities (I’ll tackle IRA, 457, and 403(b) accounts in future posts) but an employer sponsored 401(k) is most likely to also offer employer match as well.
Most people have heard of 401(k) accounts. They allow employees to save pre-tax money (money on which you have not paid taxes) for retirement. The first bonus is that employers often match some portion of your contributions. For example, employers often match 50% of your contribution up to 6% of your salary. So, for every $1000 you contribute, your employer contributes $500. That’s free money. Many employers match 100%!
Remember I said saving for the future means more money now? Employer match is one of the ways. Let’s say your goal is to save 20% percent of your salary. If your employer matches your 401(k) contributions you have to contribute less to achieve 20% so you have more money now. Here's an example (bear with me):
If you make $100,000 (for easy math) and want to save 20% of your salary you could sock away $20,000 by deducting $1667 per month from your paychecks. But if your employer matches 100% up to 6% in a 401(k) you just have to save 14% of your salary. The first 6% ($500/month) your employer matches ($500 free!) which brings you to 12% ($1,000/month). Add an extra 8% ($667) to your 401(k) and you’ve met your 20% goal by saving $1167 per month instead of $1667. That’s an extra $500 per month in your pocket. Nice.
(Note: You can contribute up to $19,500 in 2020 to a 401(k). This amount changes some years and does not include your employer match. Check the IRS website.)
But wait there’s more! More free money!
In our example, an individual with a $100,000 salary is in the 24% tax bracket and although there are lots of reasons you won’t pay exactly 24%, let's go with it. That means on $100,000 your take home pay is $76,000. So, for every dollar you earn you keep 76 cents to spend or save. Therefore, to save 20% ($20,000) of your salary with after-tax money you need to earn $26,315.79. That’s $6315 more than your goal. That’s $6315 you don’t have now to spend.
To save $20,000 of pre-tax money takes just $20,000 because you don’t give any to the man (yet, more in a minute). That's like instantly earning 24% on an investment. Thinking of this another way, if you paid taxes on $20,000 and invested the $15,200 that’s left it would take 4.1 years just to get back to $20,000 (assuming 7% return). If you invest the whole $20,000 after 4.1 years you would have $26,394. In 10 years, your $15,200 would be worth $29,900 but the $20,000 would be worth $39,343. Twenty-years? $58,819 versus $77,394, which is obviously better.
There’s another bonus after you get free money from your employer, keep money from the man, and have more money growing and compounding. Contributing to a 401(k) reduces your taxable income. If you earn $100,000 and contribute the $19,500 maximum to a 401(k) your taxable income is now $80,500, which means you pay “only” $19,320 instead of the $24,000 you would pay on $100,000. In this scenario, the 401(k) contribution would actually bump you to a lower tax bracket (22%) so you end up paying $17,710. That’s how you stick it to the man and keep $6290 in your pocket.
The bottom line, as accountants say, is that investing as much as you can in a 401(k) or other tax-deferred account is probably the simplest (it's automatically drawn from your pay) and most effective ways to grow your wealth and work towards financial independence, a secure retirement, or just more money for travel and fun.
I’m not an accountant or tax professional. In financial posts, I describe our financial strategies in the context of our situation and my research. I hope you find these posts inspiring and useful but seek actual financial advice before making financial decisions.
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