Why a 401(k) is the most lucrative investment product for most people

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Lord have mercy, my day job just recently started offering a 401(k)!

When I switched jobs last year, I was dismayed, as one can imagine, that there was no employee-sponsored retirement plan offered to me.

When I asked, as politely as I could, why the hell not, they said it was a combination of “we’re a new company and haven’t figure it out yet” and “we think there are better ways to grow wealth”.

The first response is totally understandable. Only 14% of companies offer a 401(k) to their employees, and this tends to skew to the larger companies. It’s non-trivial to set up, has lots of tax implications, and usually isn’t what a startup thinks is most important out of the gate.

The second response, well, I couldn’t possibly disagree more.

Maximum contributions

When I open a standard investment account, I have no restrictions on what I can invest in, or how much money I can use to invest. That’s pretty great.

The problem is that any gains I accrue from these investments will be taxed at the capital gains rate.

At the time of writing, the current long-term (more than one year) capital gains rate is 15% for most people. That’s better than income tax rates, but it’s still a lot. If I made $10,000, I would likely need to pay $1,500 of that in taxes, which wouldn’t be very fun at all.

Other products, such as the 401(k) and the Traditional IRA are more tax-advantaged. What this means is that contributions to these products are tax deductible, meaning that for every $10,000 you invest, you get a tax deduction of $10,000 (so at a 25% tax rate, you’d get $2,500 back).*

This is a killer deal. But there’s a snag, in that there are maximum contributions. you can’t just throw every spare dollar you have at this account.

At the time of writing, for an IRA, the maximum you can contribute per year is $5,500 ($6,500 if you are over 50). That may seem like a lot of money, but if you are going for the 15% rule for investing, then you’re going to hit that margin before you make $40,000 a year.

On the other hand, with a similar deal (some of the details differ), the maximum contribution each year for a 401(k) right now is $18,500 ($24,000 if you’re over 50), which most people won’t be able to reach anyway.

So let’s review: If you were to contribute the maximum for each account in a given year, here is the tax savings you’d gain (assuming a 25% tax rate)**:

  • Standard account: $0
  • IRA: $1,375 ($1,625 if over 50)
  • 401(k): $4,625 ($6,125 if over 50)
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As you can see here, there is a larger amount of savings to be had with a 401(k).

And this isn’t even counting the match (assuming it’s offered).

Hedging

Now all of this assumes a few things.

Assumption 1: Your 401(k) investment options don’t suck. Many 401(k)s limit the products you can invest in. So while you might want to invest in, say, a Vanguard index fund, but if your 401(k) only allows you to invest in crappy, expensive funds (or worse, company stock), then the tax advantage might not win out over the potential peril.

Assumption #2: You don’t have that much to invest. You only reap the maximum 401(k) benefit if you contribute the maximum amount. All other things being equal, if you contribute $5,000 to an IRA versus $5,000 in a 401(k), the tax savings are exactly the same.

But like I said, the IRA can cap out pretty fast for people.

Which leaves the 401(k).

So if it’s an option for you, make sure to give the 401(k) the attention it deserves in your plans for the future. There really isn’t a better investment product out there.

Do you have access to a 401(k)? Are you taking advantage of it? If not, why not?

Footnotes

* I don’t talk about the Roth equivalents here, but they are great too, even better in most cases. But even if you don’t have access to a Roth 401(k), a 401(k) is still better than not having a 401(k).

** I know there isn’t a 25% rate at the moment, but I’m using that as it makes the “napkin math” a little easier, and the real numbers will always be a little better for people.

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