If you’re employer has a 401(k) plan and you’re not contributing, it’s time to take a serious look at the financial benefits these plans offer. Company sponsored 401(k) plans allow us to deposit a limited amount of pretax income (taken from our gross pay before taxes are withheld) to an account that grows tax-deferred. This lowers our gross income for tax purposes and then later in life when we withdraw the money, it’s taxed as though it were regular income.
But a greater benefit is the immediate return on investment from the company matching provision of most plans. According to a recent Aon Hewitt study, the most common company match is now 100% of an employee’s contribution, up to 6% of the worker’s salary.
With a 100% matching provision, if I contribute $50.00 to my 401(k) through payroll deduction, it immediately becomes a one-hundred dollar deposit due to the company match. Where else can you get 100% return on your money?
The graph below shows savings growth of a $50.00 weekly contribution without the company match (dotted line) and with the company match (solid line), each earning a 6% return on investment. With disciplined savings, we could accumulate $50,000 in twelve years, but with the 401(k) company matching provision we accumulate $100,000. This also assumes that we didn’t receive a raise during those years which would increase our contribution amount, the company matching amount, and the savings total.
The news gets better because a $50.00 contribution doesn’t take a $50.00 bite out of our take-home pay.
When we contribute to a 401(k), our Federal Tax Withholdings are calculated on a lower amount of gross income because of the contribution, so less is withheld from our pay. Even though we’re depositing $50.00, it doesn’t translate into a $50.00 reduction in take home pay. Let’s look at an example using an employee earning $43,500 in annual income.
With an annual gross income of $43,500, assuming a 23% Federal Withholding tax rate, my weekly gross pay is about $836.53, the withholding amount is about $192.40, so not counting other deductions the weekly take home pay is about $644.13.
If I enroll in the company’s 401(k) plan and contribute 6% of my income (about $50.00 each week from my pay), my deposit to the plan would be made directly prior to Federal Withholdings. Assuming 23% as my federal withholding percentage, my weekly gross pay is reduced by my $50.00 pre-tax contribution, so my weekly gross pay is reduced to about $786.53. The withholding amount from this lower gross pay is about $180.90, so my take-home amount is $605.63. This is a difference of $38.50.
The difference in my take home pay is $644.13 – $605.63 = $38.50, even though I contributed $50.00 to the 401(k).
Without 401(k) contributions
Weekly Gross Pay – $836.53
Withholding Amount – $192.40
Weekly Take-home Pay – $644.13
With 401(k) contributions
Weekly Gross Pay – $786.53
Withholding Amount – $180.90
Weekly Take-home Pay – $605.63
In addition, the company has matched my contribution, so my 401(k) is increased by $100.00 and the cost to me, as far as the difference in my take home pay is just $38.50. So I actually receive a $61.50 benefit.
- Employer matching benefit (in most cases 100%)
- Taxes are paid when withdrawals begin (notice this is also a disadvantage)
- The savings grows tax-deferred
- Various investment options are available
- The money is tied up – early withdrawals carry a penalty
- Taxes are paid when withdrawals begin
- Investment options are limited with some employers
It can be very difficult to carve out a piece of our take-home pay to save, but with a company matching 401(k), even a small amount can grow into a significant retirement account.
Thanks for reading!