In our previous SquareOne blog, we discussed the power of the time value of money. Now that we understand the benefits of compound interest, we want to look at ways to kickstart your retirement savings goals.
Approximately 64% of all private industry workers have access to a defined contribution retirement plan, such as a 401(k) or 403(b). Of those workers who have access to a defined contribution plan, only 47% participate within their plan.1
Defined Contribution Plans
Defined contribution plans require you as an employee to defer or contribute a portion of your salary to an account where those funds can be invested and grow over time. For the purposes of this article, we will use a traditional 401(k) as an example. Employee contributions to a traditional 401(k) are deducted BEFORE income taxes, which means you do not pay any federal or state income tax on those dollars. Because your contributions to a 401(k) are not subject to income tax, the government subsidizes a portion of your contribution. If you did not defer those dollars to your 401(k), you would pay income tax on that amount.
For example, if you contribute $100 every paycheck to your 401(k) and you are in the 20% federal income tax bracket, the government is funding $20 of that contribution. Another way to think about it is you contributed $100 to your retirement account, but your paycheck would only be reduced by $80.
Alternatively, if you took that $100 home in your net pay, you would lose $20 of it to federal income tax. Money in a 401(k) grows tax-free until you withdraw the funds from the account. There are penalties for taking a withdrawal early (before age 59.5), with some exceptions.
Nearly 80% of defined contribution plans offer employer contributions in the form of employer matching contributions or profit-sharing. When you combine the tax benefits of saving in a traditional 401(k) with taking full advantage of an employer match, you can significantly enhance your total retirement savings each year.
Employer Match illustration
Marcus and Jennifer, both age 30, work at Smith & Company. Smith offers a 401(k) plan and matches all employee contributions up to a limit of 6% of employee salary.
- Marcus takes advantage of the full match and contributes 6% of his $54,000 annual salary. His employee contributions total $3,240 each year, and Smith & Co. contributes the full match of $3,240 each year, making the combined annual 401(k) contribution $6,480. For illustration purposes, Let’s assume Marcus’s annual salary never changes, and he earns an average annual return of 8% over the next 30 years on the investments in his 401(k). How much will Marcus have in his 401(k) at age 60?
The answer: $734,075.21
- Jennifer does not take advantage of the full match and only contributes 3% of her $54,000 salary each year. Her employee contributions would total $1,620, and Smith & Co. would match an additional $1,620 for a total annual contribution of $3,240. Over the same 30-year period, with the same average annual rate of return of 8%, how much does Jennifer have in her 401(k) at age 60?
The answer: $367,037.60
Employer matching contributions can make a significant impact on your progress toward retirement. A match is one of the few instances of “free money,” and by taking full advantage of that benefit, you are helping yourself reach the goal of retirement more quickly.
If you need more information about your employer match, contact your human resources department. They will be the best resource to help you understand the benefits of your company’s retirement plan.
1 National Compensation Survey, Employee Benefits in the United States, March 2020 U.S. Bureau of Labor Statistics
SquareOne: A Financial Foundations Blog is a new personal finance series from The Welch Group created to help provide readers with the foundational knowledge to be purposeful with money by identifying key financial concepts to help them control their financial future. Foundation topics include personal savings strategies, debt consolidation and reduction, life planning, retirement planning methods, and beginner essentials of investing and taxes.
Callie Jowers, CFP ® is an Advisor at The Welch Group, LLC, which specializes in providing Fee-Only investment management and financial advice to families throughout the United States. Callie is a graduate of the University of Alabama, is currently pursuing a Master of Accounting at the University of Alabama at Birmingham and is a Certified Financial PlannerTM.