Increasing Your 401(k) Contributions: Benefits and Drawbacks

Lately, I’ve had a lot of fun playing with Wachovia’s 401(k) contribution calculator. Ever wondered what sort of impact changing your 401(k) contribution would have? This calculator tells you based on your own information. What’s interesting is that for most people, the benefits far outweigh the drawbacks.

To play with the tool, I created a person I call “Jimmy” with the following attributes:

Jimmy wants to contribute 1% to his 401(k), and his employer will match that 1%.
Jimmy is 29 years old, and intends to work for 31 more years.
Jimmy makes $55,000 a year, and is in the 28% tax bracket.
He also pays 3% in state income tax.

This is a pretty typical situation for a person entering their thirties.

Short term costs Putting away 1% of his paycheck will cost Jimmy $32 a month in take-home pay reduction. Over a whole year, that’s $384.

Short term benefits However, Jimmy’s income tax bill is reduced by $171 by the contributions. Remember, a 401(k) contribution is before taxes, so Jimmy doesn’t have to pay income tax when he puts in the money, just when he withdraws it.

The short term balance This means that Jimmy’s total real cost for his contributions is $213 ($384 paid in, minus the $171 tax benefit). However, his 401(k) balance goes up $768 ($384 in his own contribution, and $384 from his employer). Immediately, Jimmy’s $213 becomes $768 in his retirement account. This is why employer matching is such a big deal – you simply cannot get that kind of return on your dollar anywhere else.

Long term benefits If Jimmy keeps putting in that 1% until he retires at age 60, and the investment returns 9% over the long haul, Jimmy will have $164,533 in his retirement account.

So, let’s extrapolate that a bit. If Jimmy were to contribute up to 5%, which is his employer’s maximum match…

Jimmy will lose $158 a month in take home pay. That’s the only real drawback here.

However, Jimmy will have his income tax bill reduced by $853.

Plus, Jimmy and his employer combined will contribute $3,792 to Jimmy’s 401(k). Jimmy’s total cost for that benefit is $1,043. That $1,043 instantly becomes $3,792 in the retirement account.

Here’s the kicker. For just that $1,043 a year, Jimmy will have $822,664 in his retirement account in 31 years. Is it worth reducing Jimmy’s weekly spending by $20 to make him almost a millionaire at age 60? I certainly believe so.

What’s the real story here? If you’re passing up on 401(k) contributions now, especially if your employer offers any matching, you’re doing yourself a massive disservice. Even if Jimmy could only contribute $5 a week, that adds up to about $205,000 at retirement for him – and very similar numbers apply to you.

Make it a high priority to contribute to your 401(k) at least up to what your employer will match – there is almost no better investment on earth that you can make.

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23 thoughts on “Increasing Your 401(k) Contributions: Benefits and Drawbacks

  1. Johanna says:

    I can’t follow these numbers at all. 1% of $55,000 is $550, $384 of which comes out of the take-home pay and $171 of which comes out of the tax bill. The $384 already has the $171 subtracted out – you don’t subtract it out again to get the net cost to Jimmy.

    Also, I’m not sure under what circumstances $55,000 would put you in the 28% tax bracket. I make more than that, and I’m in the 25% bracket.

  2. Jasmine says:

    What about people in their early twenties who do not get an employer match? Is it still ‘worthwhile’ to contribute to a 403(b) or rather start an non-retirement investment account? I fully fund my Roth every year and am looking for the best way to put away extra income…I currently put away 5% of my salary to the 403(b) figuring saving money is saving money, but I’d also like to save as smart as possible.

  3. BenC says:

    This is an excellent post and will go a long way towards convincing the wifey we need to save more. I can now say that if we just bump up our savings by $XXX amount per month it’s actually only going to cost us $YYY amount but we’ll get $ZZZZZZ in return in 30 years.

  4. Ross says:

    What about Roth 401(k)? You don’t reduce your taxable income now, but you don’t have to pay taxes when you retire.

  5. Steve says:

    Ross, if you expect your income and tax rate to be higher at retirement, Roth makes sense. For most people though, their monthly income goes down drastically after retiring as does the tax rate, so you end up paying lower rates in taxes with 401(k) than Roth.

  6. Johanna says:

    The Roth has other advantages over the traditional retirement accounts, though. You don’t have to take mandatory withdrawals from a Roth starting at age 70 1/2, like you do with a traditional account. (At least, I know that that’s true of the Roth IRA – I’m not 100% sure about the Roth 401(k).) And if you find yourself running up against the maximum allowed yearly contribution, the Roth allows you to effectively shelter more money from taxes than the traditional.

    Also, who knows what tax rates are going to be like 30-40 years from now? There might be a huge tax increase across the board. That, to me, is a good enough reason to have accounts of both types.

  7. vh says:

    One thing to think about, too, is what happens should you pass through the veil a little sooner than you expect…or if your investments outlive you. What effect will your chosen investment vehicle(s) have on your heirs?

    Ordinary 401(k)s and ordinary IRAs have some distinct disadvantages when it comes to whatever effort you might make to give your kids a fighting chance at staying in the middle class.

  8. frogandpig says:

    Johanna ~

    If Jimmy’s take home pay is reduced by $384 during the year due to his 401(k) contributions, but he then receives an additional $171 in tax benefits, then it does work out to only costing him $213.

    It’s different when it’s after-tax money, and then you’re right, you can’t subtract that $171. I have a simple IRA through my job, and the 10% pre-tax that I contribute does mean additional savings on my tax bill. Between my husband and myself, that adds up to substantial savings, for us saving!

    And I think that the 28% is adding a 25% federal and a 3% state tax rate.

    Just my $.02

    … which, if invested for 30 years at an 8% rate compounded monthly really equals $.22.

  9. M. Smith says:

    Is this a mistake, or can someone explain?

    From Wachovia, regarding the immediate impact on take-home-pay:

    “Assumes FICA (Social Security and Medicare) withholding of 7.65% on the first $94,200 of taxable earnings and Medicare withholding of 1.45% on any income over $94,200.”

    I thought it was a FICA tax rate of 6.2% and a Medicare tax rate of 1.45% for a TOTAL of 7.65% ???

    Also, I can’t get the calculator to work correctly at all! The closest I can get it to match my real actual current paycheck deduction is still $63 short.

  10. chris says:

    anyone know of a similar calculator for government employees? We have a 457 plan instead of 401k (we don’t get a match) and we pay medicare but we don’t pay social security.

  11. lorax says:

    I’m all for contributing at least up to the 401k match.

    But it seems that the calculator doesn’t take inflation into account. $822,664 will be worth less than half that, right?

    Also, Jim must have some significant unearned income if he’s in the 28% tax bracket while earning 55k. He can make up to $74,200 in the lower bracket, even filing single. :)

  12. Steve says:

    lorax, true. With the way the dollar’s collapsing and corresponding oil price rise, rampant inflation seems inevitable. Prices of Chinese and other foreign products are bound to reach or exceed American domestic levels in the next few years. The upside is that this will boost the domestic industry, but price-wise we’ll all be operating on a completely different much-inflated level then.

  13. Johanna says:

    frogandpig, “take-home pay” *is* after-tax pay. The $171 is 31% (Jim’s total tax rate) of $550, not of $384. And it’s $550 (plus a $550 employer match) that gets put into the account, not $384.

  14. Deb C says:

    Trent, we have a Simple IRA versus our old 401K. We put the maximum matching contribution of 5%, but we are allowed to invest at least 7.5%. However, we must direct our contributions to American Funds. Are we losing out by not contributing the additional 2.5% or am I right in thinking American Funds are dogs? We have other funds from T. Rowe Price and Fidelity left over from past employers which seem to be outperforming American by miles. Can you help us determine if it’s worth investing that additional 2.5% into the American Funds? Thanks.

  15. Michael says:

    I’ve always been amazed by how many people don’t take advantage of employee matching– like you point out here, it’s FREE money that you can never get again if you pass it up.

    My employer matches .25 on the dollar up to 6%, so the very first day I was eligible for the 401(k) I joined at 6%. The next year I bumped it up to 10% at the same time as our annual raise hit, so I saw virtually no impact on my paycheck, but I’m saving a whole lot more for retirement.

  16. Erin says:

    Great calculator-thanks for sharing that. I’ve been trying to do the calculations on my own to figure out how much we could have when we retire, but Wachovia’s calculator estimates a better # for me, I’ll take theirs instead :)

  17. sdf says:

    whos wachovia? is that a savings and loan?

  18. frogandpig says:

    Johanna ~

    What I meant is that his 401(k) contributions are taken out prior to taxes. If he was contributing the money to a retirement plan after he’d already had taxes taken out, then it wouldn’t come out the same tax benefit.

    And while I don’t have the exact dollar figures on hand for myself and my husband, by us contributing about 10% of our pre-tax income to our simple IRAs, we end up getting a massive refund. So, we end up contributing around $14,000 a year (pre-tax, which wouldn’t be that much after-tax), which puts us into a lower tax bracket at end-of-year taxes, which saves us about $5000 on our taxes, or thereabouts.

    So we save money by saving money pre-tax. If we tried to save that same $14,000 a year after taxes, it would end up being a significantly larger percentage of our pay. (And no, that doesn’t even take into account our employer match.)

    We make about $140,000 per year. Assuming a 28% tax rate, if we take 10% pre-tax ($14,000) and save it, our take-home pay is $90,720.

    If we decided to take that $14,000 out after-tax, we would have $100,800 after that 28%, then deducting $14,000 would leave us with $86,800, a difference of $3,920.

    So, not even factoring in the end-of-year tax reduction, we already saved $3920 by contributing pre-tax money to our IRAs. If you then take into consideration our employer’s match (3%, which he doesn’t match after-tax), we would then have saved $8,120, in addition to the $14,000.

    And I really do get the fact that “take-home pay” *IS* after-tax.

  19. amanda says:

    Fidelity has a similar calculator but it has more robust functionality regarding retirement age and income. If you go to Fidelity.com and click on the myPlan retirement planning made easy button in the lower left corner of the web site, you’ll get there. I don’t have accounts with Fidelity, but I like their calculator.

  20. EMF says:

    As Johanna has pointed out, Trent counted the tax “savings” twice. But the taxes are not “saved”, they are deferred. Eventually they will have to be paid. And Jimmy might have to pay taxes on some of it at higher than his current 25% (not 28%) marginal federal tax rate.

    Even though Trent has overstated the benefit, it is still to Jimmy’s advantage to participate in the 401(k) up to the point of getting all of the employer match. Anything over that should go to his Roth IRA.

  21. Brian (WA) says:

    Another disadvantage that was not mentioned is the amount of taxes that will have to be paid when taking the money out of the 401K. When that is factored into the equation the disadvantages weigh more than the advantages.

    Will Jimmy be in the 28% tax bracket when he starts drawing money out or will he be in a higher tax bracket, say 33% or higher?

  22. Peter says:

    @M. Smith You don’t pay Social Security above a certain income level, but you continue to pay Medicare on all income. Assuming the 94.2K is the income level, you pay SS and Medicare for 7.65% up to 94.2K, and then for any earnings over that you only pay the Medicare portion (1.45%).

    In general, I agree that company matching is a great benefit. Even if you’re putting in 15% and they’re puting in 5% of your salary, you’re making free money!

    With respect to the taxes, I’m assuming they’ll eventually make all income taxable, so if you’re shooting to replace some portion of your current earnings as often suggested (e.g. 75-100%), chances are your tax bracket won’t change much unless your current income skyrockets as well. In which case, we should all be so lucky :-).

  23. Jeff says:

    Absolutely you must contribute up to the max that your employer will matches — its a 100% (assuming dollar for dollar match) return on your money. You’ll never get a better return on anything. I’ve actually heard some financial planners that are pretty savvy suggest that they would rather you contribute to the point of employer match in a 401k plan vs. paying off credit card debt (still make at least the minimum monthly payment). You can never start too early saving for retirement, the difference between starting at 25 and 35 can be several hundred thousand dollars or more.

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