If you‘ll get serious about funding your 401(k), the government will pay for almost two-thirds of it.
Crazy, right? But it’s as true now as it was when I first told it to an audience back in 1991. Here’s how it works.
If you contribute 15% of your gross income (before taxes) to your 401(k) over the course of your working life, the tax breaks your retirement plan offers will return about 60% of your contributions.
In year one, if you make $70,000 a year and you contribute 15% to your plan, the tax savings in the 22% tax bracket on a $10,500 contribution would be $2,310.
And yes, the numbers I am using are being simplified for ease of explanation. They don’t account for deductions, state and local taxes, or the tax difference between capital gains and interest. But the outcome will be the same.
If you earn 7% on that $10,500 – $735 – you’d save another $161 on gains that are tax-deferred in retirement plans.
That’s a total tax savings of $2,472. I know, it’s not even close to balancing out your $10,500 contribution.
But if you stick with it through 30 years of employment (we’ll assume you never exceed $70,000 in income), the savings on the taxes deferred on the 7% growth, in most cases, will reduce the cost of your contributions.
A 15% contribution at $70,000 over 30 years adds up to $315,000.
If we earn an average return of 7% per year (again, a simplified number – the variations will move this up and down), it adds up to somewhere around $1.1 million.
But the 7% growth accounts for $746,000 of that $1.1 million, and it has accumulated tax-deferred for 30 years. In the 22% tax bracket (I know capital gains are taxed differently, but let’s keep it simple), that is a tax savings of $164,000.
Do the math. Of the $315,000 you put in, the government ate $164,000 of it. Your cost for a $1.1 million retirement account is $151,000.
And yes, even if you have only five or 10 years left until retirement, you can benefit from the tax breaks and make a significant dent in a retirement shortfall.
If you plan to work in retirement as I do, you can continue to contribute to a plan and reap the same tax benefit.
And before the accountants out there start tearing apart my example, I know this is a simplification and taxes and incomes vary over a career. But as your income grows, your tax benefit increases.
But no matter how the numbers change, the tax benefit on the growth portion of retirement accounts is too often glossed over, and it will fund a large portion of your contributions.
Get serious about your retirement and stop giving away the free money Washington is throwing at you.