Taking Advantage of the Real Benefits of a 401(k)
Both traditional 401(k)s and traditional IRA accounts both allow us to defer the income tax we would have otherwise paid on our contributions and invest this money over the long term, given that the plan is to not touch this until retirement, which is usually many years away when we contribute to the plan.
This will give us ample opportunity to profit from this deferred tax and we do get to keep it for as long as our contributions remain in the plan. There is also compounding involved where the earnings from this extra money also generates returns over a long period of time as well, and this can have us earning quite a bit more money in our retirement account than would otherwise be possible.
401(k) plans also generally have the benefit of having our employer contribute to our plan for us by matching our contributions, and this where the real power of 401(k)s come from. This money from the matching will also grow over time and together with the extra money that we get to use from the money we didn’t pay in tax, this adds up to quite a bit extra, even at relatively modest 50% match levels.
If we assume that we’ll double our money over time, which is not an unrealistic goal for a long-term retirement account, we can easily see how this extra money that we get to use with tax deferrals and the extra that our employer puts in can combine to really shoot up our overall returns when we end up needing the money.
If we take $1000 that we would have otherwise spent and contribute it to a 401(k), with a 50% match, at a 25% tax rate, we are starting out with $2666, or an extra $1666. It’s the extra part that matters since this is what we are passing up on if we do something else with the money other than put it in our 401(k).
This amount doubles, so in the end we’ve now got $5332. We will have to pay tax on this so let’s assume that our tax rate in retirement has dropped to 15%, meaning that we’ve netted $100 in tax savings on the original $1000 from putting off paying tax on this until retirement.
We’ve made a total of $4332 from this original $1000 though, in comparison to the $100 which was the tax savings on the principal. Instead of just doubling our money, we’ve increased it to over 5 times its original value, which is a very significant difference. This shows us just how powerful 401(k) investing can be, and how much of the earnings come from compounding returns on the borrowed tax money and especially the employer match.
Seeking to Maximize our Advantages with a 401(k) Plan
When it comes to deciding whether to contribute to our 401(k) or spend the money, we need to realize the great advantages that can be realized with contributing it instead, and ensure that we really are putting in as much as we comfortably can. This may involve seeking out a little less lavish lifestyle now, but this is not just a matter of delaying the benefits of this money, it is about looking to seriously increase them later versus setting for quite a bit less now.
What we get out of our 401(k) will be directly proportional to what we put into it of course, and how well we do with this will always come down to our willingness and ability to set aside a good amount of our funds toward this goal. When people decide how much they will save for retirement, it’s mostly a need-based calculation, and we usually will give our future needs shorter shrift than we really should, due to the greater appeal of enjoying money now rather than later because the benefits are more proximate and tangible when we take advantage of them now.
We often will convince ourselves that many things that are actually highly discretionary are somehow necessary and basic to the extent that they seem to preclude setting the money needed for them aside. The list here is rather long, and if we have a hard look at what we spend our money on we can easily come up with a number of things we spend money on that might not be quite as necessary as we may have thought.
This is not to say that we need to be overly frugal and shoot for a better lifestyle in retirement than we had while we were working, although if we look at all this from a perspective of overall value, the power of 401(k) accounts will actually have us doing just that.
When we look at present versus future value with non-retirement savings, we generally end up in a similar place, where we may enjoy some modest benefits by saving and beating the rate of inflation by a small amount over time. These future benefits are worth a little less to us because we have to wait so things sort of even out, and the concern with retirement then becomes not having us drop too much to make things too difficult.
401(k) benefits provide a different situation though because the difference won’t be small, especially with our employer kicking in their money when we put ours into our 401(k). In this case, the more we can put into the account the better from a purely long-term financial perspective the better off we will be, and not just a little better off either.
It’s too much to expect people to do this though because we do need to be concerned about our comfort levels along the way and not just in retirement, and there is the matter of extra money over and above what we’d be able to live happily on being worth less dollar for dollar than spending it to seek to achieve a similar level of comfort now, and the principle of looking to achieve balance is therefore a good one.
If anything, we should want to err on the side of caution and contribute a little more to the 401(k) than we would have to just balance things, due to the uncertainty of the future. We don’t really know exactly what we will need, where the price of things is going, how long we may live, what circumstances may arise in our final years, and so on, so it does pay to be more rather than less prepared for these contingencies.
Managing our 401(k) Accounts Along the Way
Aside from contributing enough to our 401(k), it is also important to look to manage our accounts in a way that will provide us the best chance of success. While we are shooting for much bigger overall returns than with standard investing with no tax deferrals and no matching, and this does provide us a very nice buffer against downturns and risk, we still need to look to manage these things.
The great majority of investors choose not to participate in managing their accounts and just invest in the funds and let the funds do it all for them. What we don’t realize is that these funds have their own objectives, which are to see them grow under the constraints they are under and have no real direct bearing on our situation.
A good example of this is with a stock index fund, its sole goal is to track an index, wherever this may take them. In both good and bad times, it will just continue to track the index. Whether we should be in or out at any given time, or what may be best for us in any way, isn’t part of any of this, and our following this blindly isn’t much different than just pointing our car in a certain direction and then continuing to drive without any concern of what obstacles may end up in our way.
It is better of course to actually look to steer the car, and the car will not do this for us. The concern for us, our obstacles with our 401(k), is the periods where the funds that we are in are not performing well, and especially when they are performing very poorly.
Losing ground in the markets isn’t as inevitable as we tend to think, and during these times we are actually choosing to stick around and bear the losses that we do instead of choosing to put at least some of our money in better performing investments when this happens.
People will think about such things but they tend to look at similar investments as alternatives, a different stock fund for instance that may have done a little better, losing less money in this case, and then want to switch things up within the same class of investments when they should have realized that the class as a whole is suffering and they should be moving away from it more during these turbulent times.
We do have the means to help ourselves if we are up for it, by switching investment classes depending upon how they are faring, as well as rolling over some of our 401(k) money to an IRA which give us even more flexibility in bear markets. With an IRA, we can even purchase inverse index ETFs which make money when the market goes down, and at the same time move out of stocks with our 401(k) and into bonds or a cash-like investment as the situation dictates, and make rather than lose money during these times if we handle things well.
Together with contributing as much as we reasonably can and managing this money in a sensible way, realizing that the performance of our 401(k) portfolio is ultimately up to us whether we choose to take responsibility for this or not, we can really help ourselves a lot in our retirement years and take this often stressful time of our lives and turn them into a more comfortable and enjoyable experience.