You’re probably tired of the ‘bags of money’ parable. Do you know what I’m talking about? I’ve heard it dozens of times in financial podcasts, and I’ve probably read it a few dozen more. It goes like this: pretend that as you’re leaving your workplace at the end of the week, your employer sets up a folding table and places bags of money on it. Better yet, your name is on one of those bags of money. Would you take that money? Of course you would. The financial magician telling the story then reveals his sleight of hand: the 401(k) employer match was the free money he was talking about all along! The sound bite takeaway: always take the company match because it’s free money.
I agree with this, by the way, so I’ll repeat: you should always max out your company match. But I think we do a disservice to the average investor to stress this and only this aspect of their 401(k). Because there is an equally powerful benefit to a 401(k), but I fear most people who receive this benefit are squandering it.
A 401(k) is a tax-deferred retirement plan, which means that each year you invest in it, your taxable income shrinks, and therefore your tax bill shrinks. Put more plainly, your employer isn’t the only one giving you free money: the IRS is, too. Depending on your tax situation, this manifests itself as either a smaller tax bill or a larger refund. Eventually you’ll pay it back as taxes when the 401(k) money is withdrawn in retirement (the whole ‘deferred’ part), but for now it is money in your pocket, almost like an interest free loan. In my opinion, if at all possible this money should be invested so that you extract the maximum benefit from your loan. I doubt many do, though, and I think it’s because this gift is hidden in the generic bucket of money labeled “taxes”.
I call this a ‘color of money’ problem (mostly because I like the Tom Cruise/Paul Newman movie of the same name, though I don’t think 401(k)’s played a prominent role). Because the tax money all looks the same, it is difficult to mentally break it up and understand where it’s coming from. But we can fix that. The simplified spreadsheet below shows roughly what you will receive based on your tax bracket and amount invested under the two most common filing statuses.
Note: These tax are 2014 tax brackets
Once you identify your tax bracket and the amount of money you’re investing into your 401(k), the number in light green shading reflects roughly what the IRS is giving you each year. Again, this is highly simplified. For a more complete picture of the same information, this Bankrate calculator is more complex to use but very helpful.
With a number in mind, it should now be possible to capture this money for investment, either by removing it from your tax refund yearly or reducing taxes withheld on a weekly basis. And now that you know your rough number, you know that by increasing your 401(k) contributions, you can increase it as well. If you can afford it, why wouldn’t you want a bigger loan?
Think of it this way: Imagine that Uncle Sam sets up a table outside your workplace…
The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities.