Saving for retirement is a difficult endeavor. So why do it alone? The good news, for folks that are fortunate to have access to an employer-sponsored retirement plan, is that you don’t have to go it alone. Charlie Epstein, the well-known retirement plan consultant, educates 401(k) participants to understand the power and leverage of using “other people’s money.” The concept is simple, but often overlooked.
401(k) funding begins with the participant deferring his or her own income via a payroll deduction and subsequent deposit into the plan. So, the account balance begins with the participant’s own money. Then, assuming that the contribution is made on a pre-tax basis, Uncle Sam offers a tax rebate for each dollar contributed – which results in a significantly lower net contribution.
Further, if there is a matching program, the employer will contribute to the participant’s account based on a pre-determined formula. For example, if the employer matches 50 cents to the dollar up to 6% of earnings, a participant with a $60,000 income and a $3,600 plan contribution will receive a $1,800 “add” from the employer. Of course, contributing at a level below the employer’s maximum match is equivalent to leaving money on the table.
Finally, contributions to the plan from all sources will be invested in a portfolio of the participant’s choosing. If the participant is able to commit to maintaining a traditionally balanced “growth & income” portfolio, and not overreact to short-term volatility, the investment markets will be sufficiently generous – a 7% average annual return over the long-term is a reasonable expectation.
In order to better see how a savvy participant may leverage “other people’s money,” let’s put each of these components into a real-life scenario, based on the following assumptions:
- Your income is $60,000
- Your 401(k) savings rate is 10%
- Your Federal tax rate is 25%
- Your employer matches 50% of your contribution up to the first 6% of your earnings
- Your average annual rate of return is 7%
- You save for 25 years
Total Payroll Deduction (Cumulative)
Uncle Sam’s Contribution (Cumulative)
Net Personal Contribution (Cumulative)
Employer’s Contribution (Cumulative)
Market’s Contribution (Cumulative)
In this scenario, your 401(k) balance is $493,342. How did you get there? You put in $150,000, yet Uncle Sam gave you $37,500 in tax savings – lowering your net contribution to $112,500. Your employer added $45,000 and the market generated $298,342 in portfolio gains. Leverage / Compounding / Combining Forces = SUCCESS!