Why you should contribute to your 401k – part 1

There are two types of 401k accounts: traditional 401k and Roth 401k.

  • A traditional 401k account is a retirement savings account that individuals can invest in before it is taxed, i.e. pre-tax. One of the greatest advantages of 401k investment is that many employers are willing to contribute to their employees account through some level of matching.
  • A Roth 401k is an account that is contributed using post tax money. In this post, I will focus more on traditional 401k accounts. I will address Roth 401k in a separate post along with Roth IRA.

Should I contribute to my traditional 401k? I have heard this question from friends and family more than a handful of times. When I was a resident (physician in training), my program offered a 100% match to a plan similar to a 401k, up to 5% of my total income. My salary was about $50,000 at the time and I was living in one of the most expensive cities in the country, but I didn’t think twice about maxing out on my contribution every year. It was an instant 100% increase to my initial contributions plus whatever capital gains accumulated over the rest of my career (Remember, the longer you invest, the more your initial investment will grow.) Not all 401k plans receive a 100% employer match. Is 401k worth contributing to if there is no employer match? My answer is almost always yes.

How important is it to contribute to your traditional 401k? Remember Jenny the high school teacher from my previous article? Jenny is not a professional in the financial world, but she is financially literate and manages her own finances. She is hardworking and lives a frugal lifestyle because she wants to have a secure retirement. Jenny’s employer does not match her contributions (many employers do!) but that doesn’t stop her from investing in her 401k. The money is taken out of her paycheck by her employer to be deposited in a retirement account every month. Consequently, her monthly paycheck seems smaller, but it is to her advantage in the long run. Let me show you why.

Note: I am using “401k” and “pre-tax account” interchangeably in this article, but they are not exactly synonymous. A 401k is only one of many types of pre-tax retirement account. I am also treating post tax account and taxable account interchangeably in this article. That is also not completely accurate. A taxable account is only one type of post tax accounts. A Roth account is also technically investment of post tax as well.

Note 2: if Jenny parks the money in her 401k account and doesn’t invest it, the growth will be negligible. That is no good. I will write another article on how to appropriately invest that money.

  Jenny investing pre-tax Jenny investing in taxable (post tax)
Jenny’s Salary

$55,000

$55,000

Money invested pre-tax (401k)

$15,000

0

Taxable income

$40,000

$55,000

Federal marginal tax bracket (Single)

15%

25%

Effective tax rate

9.86%

12.45%

State tax (I am using North Carolina as an example)

4.65%

5.75%

FICA (i.e. Social Security)

7.65%

7.65%

Post tax income (i.e. take-home pay)

$31,136

$41,517

Rent

$12,800

$12,800

Food/car/fun

$15,600

$15,600

Money invested post-tax

$0

$12,000

Money in checking account at the end of year (Just-in-case money)

$2,736

$1,117

There are three notable differences between Jenny’s budgets when she decides to invest pre vs. post-tax.

  1. The amount of money Jenny can invest in pre-tax is more than her post tax investment. She is investing $3,000 more in the pre-tax account (i.e. 401k) and still has more money left in her checking account at the end of the year. Remember the $15,000 she contributed to her 401k is not all hers. Uncle Sam will claim a portion of it when Jenny is ready to withdraw for her retirement. I will break down how much of her savings goes to taxes in part 2 of this article.
  2. Jenny has reduced her taxes in two ways:
    1. Jenny pays taxes on less money after contributing $15,000 to her 401k account. In the meantime, IRS acts as if that $15k doesn’t exist when calculating Jenny’s income taxes. As a result, she pays less income tax this year. Despite contributing $15,000 to her 401k, her take home pay is only about $10,000 less than if she invested nothing at all in her pre-tax account.
    2. Jenny has bumped herself down a federal income tax bracket, thereby reducing the percent of her money that goes to taxes. Our tax system is “progressive” meaning people making more money are taxed at a higher percentage (in effective tax rate). Jenny legally sheltered $15,000 from federal and state taxes and dropped herself down to a lower bracket.

Are you curious how Jenny fair over her career had she persisted with the current investment regimen?

Let’s assume that market returns 7% (a very conservative projection of market return considering US stock market’s return over the last 50 years) a year. Remember that all Jenny’s contributions to her pre-tax 401k account will not be taxed until she is ready to retire and make withdraws. As long as the money stays in the plan, she doesn’t have to pay a penny of tax on it while she’s working.

  Pretax investment Post tax investment (taxable account)
Jenny’s nest egg after 20 years

$651,158

$520,9276

Jenny’s nest egg after 40 years

$3,281,0176

$2,624,813

These results were calculated assuming Jenny contributed to her pre-tax or post tax accounts consistently every month through her career. The market gain of 7% is compounded over her career which makes the growth exponential.

In conclusion, I’ve discussed the immediate benefit of contributing to your pretax 401k account. First, I showed you how Jenny lowered her yearly income tax. Second, I demonstrated how Jenny end up with a larger nest egg to retire. In Part 2, I will go over some of the details on how pre-tax (401k) and post tax (taxable investment) are taxed during retirement.

Interested in learning more about personal finances? Read more here.

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