In a couple previous posts I used examples to explain compound interest and the Future Value formula. In my examples I used $5,000 as the value of our annual contributions. I also mentioned that, while $5,000 a year is a lot of money, it probably is within reach of everyone. This post will show you how to use contribution matching of 401K funds plus income tax savings to save 40% on your contributions toward Financial Independence.
By the way, there’s nothing magical about $5,000 a year. That’s just a number I used in my examples. But, I’m going to stay with it since you now know that $5,000 a year could be invested to give you around $1.5 million. $5,000 a year works out to $416.67 a month. We’ll round it up and call it $417.
If there were no way for you to get help making your contributions, saving $417 a month for 40 years is still worth it. You’d contribute a total of $200,000 to your savings. But, with the power of compound interest, you’d end up with around $1.5 million! That’s awesome! I’ve seen these numbers hundreds of times and it’s still exciting to think of how well this works!
But, what if I told you there was a possibility where you could contribute 40% less, and still get the same results? That means instead of contributing $417 a month you’d only need to contribute $250. Your total contributions after 40 years would equal $120,000 instead of $200,000. That is 40% less, and even more awesome!
Setting Up the Example
Like so many of my posts, let’s walk through a quick example for the explanation. As with any example, this one may not completely match your specific circumstances. But, you’ll get the idea and be able to apply the principles to your situation.
Here’s our scenario. Janice earns a total of $50,000 a year. Her employer offers a 401K with contribution matching, and she plans on staying with them long enough to cover the vesting schedule. (If you feel like what I just said was over your head, stop now and go read my post: Your Quick Start to Financial Independence.)
The amount of money Janice’s employer matches is 50% of her contributions up to 6% of her income. (This is pretty typical in places where I used to work.) She’s in the 15% tax bracket because of a combination of her $50,000 annual income and her deductions. This means that the last dollars she earns for the year are taxed at that rate.
Putting the Example Into Action
Janice contributes $250 a month, or 6% of her salary, into her company’s 401K plan. That’s a total of $3,000 in contributions for the year. The company matches each monthly contribution of $250 with $125 of extra money! $125 a month works out to $1,500 in extra contributions a year from her employer. This raises Janice’s total contributions for the year up to $4,500! She’s almost there. But wait! There’s more!
Janice would normally have paid 15% in income taxes on the $3,000 she contributed for a total of $450 in taxes. But, since she contributed her money into a 401K, she’s no longer taxed on that income. So, whereas before she would have paid $450 to the IRS, she gets to keep that money. This is found money! It’s like finding a twenty-dollar bill in the cushions of the couch! She could spend it. But, since she hadn’t planned on having it anyway, why not contribute it to her savings? She could easily open an IRA and contribute the $450 there.
This raises the total to almost $5,000. Janice contributed $3,000. Add the $1,500 in matching contributions from her employer, which gives her $4,500 in contributions. Then add in the $450 that she saved from the IRS and she’s got $4,950 in contributions for the year. For me that’s close enough. But wait!
When Janice contributed the $450 into her IRA that money is now not taxable! 15% of $450 is $67.50. Again, this is found money—money that Janice wasn’t expecting to have because she would have paid it to the IRS. So now she can contribute that money into her IRA. This raises her total contributions for the year up to just over $5,000!
This works if you are a single-income family earning $50,000 or a two-income family earning a combined total of $50,000. In case of the two-income family both partners would contribute to their individual 401K’s and IRAs.
Picking Your Strategy
Depending on your circumstances, one of these contribution strategies is for you.
If your employer offers matching of your 401K contributions take the following steps:
- Sign up for your company’s 401K and contribute only enough to get ALL of the matching funds. If you still have money that you’d like to contribute toward your Financial Independence do the next step.
- Contribute money into an IRA. Contribute until you reach your maximum IRA contribution for a year ($5,500 if you’re under 50 years old, or $6,500 if you’re 50 or older). If you still have money to contribute, do the next step.
- Go back to your Personnel or Human Resources department and increase the amount they withhold for your 401K by the extra amount you want to contribute. The annual contribution limits for a 401K (in 2017) are $18,000 if you’re under 50 years old, or $24,000 if you’re 50 or older. You won’t receive any additional matching of your contributions. But, you’ll get to contribute pre-tax money that will grow tax-deferred, which is still important.
If your employer doesn’t offer matching of your 401K contributions take these steps:
- Contribute money into an IRA. Contribute until you reach your maximum IRA contribution for the year ($5,500 if you are under 50 years old, or $6,500 if you are 50 or over). If you still have money to contribute for the year, do the next step.
- Contact your Personnel or Human Resources department and start your 401K with the additional money you want to contribute over and above what you contributed into your IRA.
Following these steps will give you the most control over your money. The IRA will give you the most flexibility in investing your money. Plus you will most likely significantly reduce the management and administrative expenses. Having said that, you should never pass up contribution matching in a 401K when it’s offered. Your employer and the federal government have both created great incentives for you to save for your Financial Independence. It pays you greatly to take advantage of those incentives.