Saving and investing wisely is not an easy achievement. How much do you need to save for retirement? Where should you put your money? There are thousands of financial advisors who offer differing opinions on these matters. But if there is one utterly clear maxim of saving for retirement it's this: contribute at least enough money to your 401(k) to maximize your employer's contribution.
Much to my shock and dismay, 39% of 401(k) participants don't follow this totally noncontroversial advice, according to a new study by Financial Engines, via the NY Times Bucks blog. That's crazy. Here's why maxing out your 401(k) is the biggest financial no-brainer you'll ever encounter.
When your company promises to match some contribution to a 401(k), it's like giving you a raise. Refusing the match is like telling your company that you don't want extra money. Imagine an example where you make $1,000 per paycheck. Now imagine if your company agrees to match 50 cents per dollar up to 6% of your 401(k) contribution per paycheck. That means you can put up to $60 per paycheck into your 401(k) and your company will also contribute $30.
Did you see what just happened? You got a 3% raise. Sure, you had to contribute $60 of your gross income as well, but this money just becomes savings -- something you will surely need some day anyway. Unless you are one of the few people who believe Social Security alone will be sufficient to allow for a pleasant, comfortable retirement at a reasonable age.
Moreover, that $60 you contribute doesn't reduce your take home pay by 6%, because it's taken pre-tax. For example, let's say after all taxes are taken, your income would normally have been 30% lower. If you didn't contribute to your 401(k), your after-tax income would be $700. If you contribute $60 pre-tax, however, your after-tax income is $658 -- only $42 less, instead of $60. This is the second reason why it's so great to contribute to a 401(k): you can delay taxes on that money, so you won't feel like you're saving as much as you actually are.
Let's reflect on this scenario where you contribute to your 401(k) as described above. Your after-tax income declines by $42, but you save $90. This is one of the best deals you'll ever get, and it's virtually impossible to beat.
Let's consider poor reasons not to contribute enough to receive your full employer match:
I Want More Freedom Investing
Maybe you don't like your employer's 401(k) plan. You hate mutual funds. You think you can do better on Scottrade. Good luck with that. In the example above, imagine if you decided to shun your 401(k) and invest $42 (the difference in after-tax income) from each paycheck yourself instead. You would need an investment that would more than double your money -- even if you saved your 401(k) as pure cash. The return would have to be 114% to get $90.