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Employer 401k Match: Step 7 on the Path to Financial Independence
Does your employer offer a 401k match with contribution program and do you contribute enough to get the full match? I hope if you are reading this you understand the importance of saving for retirement so I’ll skip that. What is more important here is saving for retirement with someone else’s money. The 401k match is essentially your employer giving you free money for retirement as long as you save too.
A 401k match is basically free money
Employer 401k Match
Not participating in the employer 401k match is functionally turning down part of your salary, so you should have a good reason for doing so. If your employer offers a 401k retirement plan and you aren’t taking advantage of it by this step in the journey, you need to get on that right away. If you are self employed, much of this may not apply so bear with me since the rest of it might still be useful to you.
First, some basics
Assuming you have access to a 401k and contribute now or plan to very soon, there are some basics we should cover real quick. First, there are two main types of accounts worth discussing (for the vast majority of employees, other jobs like government workers and military have access to additional types not discussed here): the traditional and the ROTH 401k. I won’t get into the legal, accounting, and otherwise deep differences between all of the options because there are far better resources on the web to handle that and I’m just here to make sure you understand the importance of this tool.
The quick version of the difference between these two is how they are taxed. Traditional 401ks are not taxed on the money going into the account but taxed on the money exiting whereas the ROTH version is the opposite. Since I believe that most people would benefit more from the traditional 401k as it reduces your taxable income now and we may be able to structure our withdrawals in the future to be in a lower tax bracket I’ll discuss this account type the most here. Also, many companies don’t offer the ROTH 401k as an option anyway. If your company offers both, evaluate your situation in life, and do some research on which option is more optimal for you.
Read more from the experts
Fidelity has great resources on their website on how to pick the type of account you are using to save for retirement. I personally use Fidelity for our IRA savings accounts and find them very easy to navigate and work with. It helps that my employer uses them for my 401k as well to keep most of my accounts in once place. Even if that wasn’t the case, Fidelity has all the accounts you need and a wide selection of low-cost index funds to invest your money into. I wish they sponsored me to say that.
JL Collins, one of the leading voices in the financial independence community, has many posts on where you should be saving your money. His Stock Series of posts, which I cannot recommend enough, has an entire page on tax-advantaged versus regular accounts. Bookmark that page and make sure to read that entire series when you get a chance because it will change your life.
401k Match: free money with a catch
One of the main incentives to participate in the company 401k as opposed to your personal IRA account aside from the higher annual contribution maximums is that your company will typically match your contributions to some degree. This is functionally free money you would only get from your employer if you contribute to retirement.
Warning: math ahead
Sometimes the match calculation is a simple dollar-to-dollar match up to a predetermined threshold like 5% of your salary or $5,000 which is great for simplicity. Some companies will convolute the calculation to, in my opinion, reduce their burden or appear more generous than they are by offering to match 25% of every 1% you contribute up to 4% of your salary. At first pass, this might seem nice… until you do the math and realize if you contribute 4% of your salary they will add in 1% and suddenly it doesn’t seem so charitable.
I’d like to pretend that these examples were invented for the purpose of illustration in this article but they are real 401k match offers I’ve seen in the past. Even the HR representative on the second one had a hard time wrapping her mind around just how small the match was despite the way they worded the match calculation.
One of those catches I mentioned
One caveat to the free money your company deposits in the form a match is that it isn’t initially yours to keep. It slowly becomes yours over time according to a vesting schedule that your HR department should be able to provide you with. An example vesting schedule could be you can claim ownership of 25% of the amount each year for 4 years at which point all matched deposits are yours free and clear. If you leave the company before any of those funds become “fully vested” the company gets them back so be aware of that stipulation.
You do you, but try to at least get a full 401k match
The percent of your pay you contribute with each paycheck is a personal decision at this point but I wholly recommend you contribute the minimum to get the full match from your company. If you can’t contribute that amount right now, that is perfectly ok. The best method to slowly increase that percent is to increase the contribution amount every time you receive a raise or promotion. If your annual raise is 3%, consider bumping up your 401k contribution by 1-3% at the same time. Your paychecks will functionally look the same as they did last year and you get closer to your goal of being financially independent that much faster without feeling any financial shocks.
Honestly, at this step of the journey to financial independence, you should contribute the amount necessary to get the full match and nothing more. You’ll probably end up contributing more down the line but right now we need to evaluate other, more pressing uses for those funds before going hard on the 401k. Additionally, there are maximums you can contribute pre-tax per IRS guidelines and other considerations.
You should’ve already started, but that’s ok
The optimal time to start contributing to your 401k is yesterday. I know that is cliche but it’s the truth. You probably knew that even if you weren’t following through on the idea. “Time in the market” will generally always beat out trying to “time the market” and the longer you have your money invested the more likely you are to have a solid sequence of returns.
- 401k Match Growth Study
- Average salary during this is $50,000 annually
- Contribution is 5%
- Company Match is 100% up to 5% (so 5%)
- Average investment return is 7%
|Invested per Year
|Match Per Year
|Combined Per Year
Time really is money…
The table above illustrates that even a $50,000 salary contributing 5% annually with a 5% match by the company will end up with dramatically different ending balances over longer lengths of time. You can see that between 25 and 30 years, this person would only be personally contributing $12,500 from paychecks but their balance will be $170,000 higher because of the compounding gains on the entire portfolio.
The differences aren’t quite as stark on the shorter time frames but still a substantial amount of money. Enough money to convince you to make sure you are doing whatever you can to fit this into your monthly budget as soon as possible.
Learn from my mistake
One of the small regrets in my financial life is not starting my 401k earlier in my career. I never opened a 401k working my first job out of college because I felt like I had a long time to save and wasn’t making enough money to set any aside yet. Looking back, that was nonsense because I was saving most of my money anyway in a regular savings account and could’ve done so in a tax-advantaged account instead.
I probably could have saved money on my taxes too by reducing my taxable income and ended up with more money in the account thanks to long term compounding gains. Contributing 5% of my salary at that point, which was much lower than now, wouldn’t have been a lot of money in retrospect. It just seemed like a lot at the time.
If your employer offers to match your contributions to a 401(k) or equivalent, make sure you are getting the full match. This is functionally income you are missing out on by failing to participate.
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