The One Reason You Should Be Maxing Out Your 401(k)

By on March 23, 2013

The One Reason You Should Be Maxing Out Your 401(k)

Compound gains or compound interest.

"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it." -- Albert Einstein

I'm sure you've all heard the question "Would you rather have $1 million now or $0.01 doubled every day for 30 days?"

Without thinking about it most people immediately answer $1 million, but if you do the math you will find that $0.01 doubled every day for 30 days will end up turning into $5,368,709.12.  Now which would you rather have?

There are actually several very good reasons to max out your 401(k); security in retirement, tax advantages now, tax advantages when you retire, and tax free growth are some of them.  In the end though the main reason is those compound gains.

Consider this:

A 35 year old person with 30 years until retirement and making $50,000 per year.  The person contributes 10% of their salary ($5,000 per year) to their 401(k) and is expecting an 8% annual return.  At the end of 30 years they would have accumulated $566,416 in their 401(k).  This scenario also doesn't take into account future salary increases or the possibility of an employer match (for the sake of simplicity).

Now consider the same amount of money, $5,000 per year, invested in a taxable account.  First of all, around $462 of the $5,000 yearly contributions will be lost to taxes (assuming a single filer with no dependents).  So, our fictional saver now has just $4,538 a year left to invest.  If they also put this money into an investment yielding 8% annually after 30 years they would be left with just $385,729 or $180,687 less than in the tax deferred 401(k).  The difference is not only because they are able to save less after paying taxes, but also because they have less left each year after paying taxes.  For example, in the final year, their investment account would have grown by $29,974 over the prior year, however they would be required to pay out $7,494 in taxes.  As you can see, taxes bite you twice.  Before you get the chance to invest and then again as your investments grow.

While it may seem as if the tax savings are the most important part of the 401(k), and those savings are very important, it's the fact that you are losing the compound growth on all those tax dollars that really hurts your savings and investments the most.  Every single dollar you can allow to generate interest and compound will return you many times over when you are looking at a time horizon of 20, 30, 40 years or more.  If you want to play with your own numbers a bit there is a simple to use calculator here that will show you the difference between a taxable and tax advantaged account.

So, remember the one reason to max out your 401(k) (and all tax sheltered accounts for that matter) rests not so much on the tax savings (though those are also important), but rather on the compound growth you give up when saving money in a taxable account.


 
Steve Walters
Steve Walters
Contributing Writer at ExcelLiving.com
Steve blogs about personal finance at his site Money Infant. After paying off over $40,000 in debt in less than 3 years, he and his wife sold all their stuff and moved across the world to Thailand with their 1 year old in tow. Needless to say it's been an adventure. He is also available for freelance writing assignments and can be contacted here
Steve Walters

Latest posts by Steve Walters (see all)

You might also like this