David H. Kinder, RFC®, ChFC, CLU
Should you maximize your employer's 401(k) match? Let's do the math on that.
Updated: Jan 18
It is common traditional financial advice that everyone "should" maximize their employer matching contributions on their 401(k). That sounds like good advice, because if you don't, you give up "free money", don't you? And it would cost you a boat load of future retirement assets and lower your standard of living in retirement, right?
On the quality of the match being offered.
How do we know that the employer match is of quality?
We need to do the math on it.
Let's start with a $1 for $1 match and let's say it's up to 8% of your salary.
Employee contribution: 8%
Employer contribution: 8%
Total contribution: 16% of your annual income being contributed.
Sounds good right?
Here's the part that is NEVER talked about: Taxation in retirement.
How much in taxes will you have to pay when you take money OUT? What direction do you BELIEVE taxes will be in the future? That must be a part of the equation before you just shell out dollars - particularly if you are contributing ABOVE the match.
Here's the calculation: Turn the % into $. Employee contribution: $8
Employer contribution: $8
Total contribution: $16.
Your goal should be able to take out YOUR CONTRIBUTION + as much as possible of your EMPLOYER'S CONTRIBUTION AFTER TAXES.
How much would taxes need to be at or lower for you to take out your own contribution "tax-free"?
Employer Contribution ÷ Total Contribution = Tax %. $8 ÷ $16 = 50% tax bracket.
Without going into a conversation about how much your standard deduction would be and how much income, let's simply look at how much would be subject to taxation given various tax brackets:
If you retire, and you're in the 50% tax bracket: Then of your $16 total contribution, your EMPLOYER MATCH of $8 would be subject to income taxation so you could get YOUR CONTRIBUTION "tax-free". That's an oversimplification, but that's essentially what would happen.
You see, the employer isn't just giving you money. They are taking a current year tax deduction for contributing to your retirement plan. Well, the IRS wants that money to grow so they can tax it later. So OUR job is to help you "beat the IRS (legally) at the retirement savings game".
Would you likely be in the 50% tax bracket? If we look at TODAY'S taxes (2018), you would need over $600,000 of annual income if you are married, filing jointly... to be in the 37% tax bracket. That doesn't describe most typical retiree income.
Because that is generally unlikely to happen, a dollar for dollar match would seem to be a 'good deal' because you can generally count on keeping a good portion of your employer's match for yourself. The only "catch" at this point would be if you're saving ENOUGH?? (More on this later.)
However, what if your match ISN'T $ for $. What if it's 50¢ per $1 contributed? How would that change the equation?
Suppose the match is now 50¢ per $1 up to 8%.
Employee Contribution: $8
Employer Contribution: $4
Total Contribution: $12
Now, how much would taxes need to be at or lower for you to take out your own contribution "tax-free"?
Employer Contribution ÷ Total Contribution = Tax %. $4 ÷ $12 = 33%
Now, to "beat the IRS (legally) at this game", we would need to retire at the 33% bracket or less to get our own contributions out "tax-free".
In today's taxes (2018), you would need to be earning $157,500 or more (married filing jointly) to be in the 32% tax bracket. While that's certainly not $600,000... most retirees would be just fine, even with a 50% match.
What if there is NO MATCH on your contributions?
OR if you are contributing ABOVE the employer match?
Employee contribution: $8
Employer contribution: $0
Total contribution: $8
Now, to get your OWN money out... well, it's ALL TAXABLE! Let's assume a conservative tax-bracket of 15%: $8 x 15% = $1.20 taxes if retiring and filing married filing jointly, with a total income of under $77,400.
For every dollar you contribute above the employer match, that reduces the tax-bracket percentage for which you can just get your OWN money back out 'tax-free'.
You might say "$1.20 out of $8 isn't bad"... and you'd be right... but that does assume that you're taking it ALL out in a given year.
However, will taxes be this low forever? I highly doubt it.
Don't forget that all distributions from IRS qualified plans can also make up to 85% of your Social Security retirement income benefits subject to income taxation:
This video goes into a little more detail:
What if, you could retire with a ZERO percent tax-bracket?
What if, you could retire with money that would NOT subject your Social Security Retirement Income to taxation?
What if, you could never lose your long-term retirement savings because of the stock market?
What if, you could get access to your retirement savings PRIOR to age 59 1/2 for emergencies or opportunities?