Deep Dive: This long-term investment leads to a guaranteed 100% return on Day 1
As we head into 2017 and consider New Year’s resolutions that usually involve dieting, here’s an idea that can make you, or someone you care about, a lot of money: Take full advantage of the company 401(k) match. Yes, a lot of money.
In May 2015, Financial Engines released the results of a study that concluded workers in the U.S. were leaving $24 billion a year on the table because they don’t contribute enough to take full advantage of employers’ matching 401(k) retirement-plan contributions.
A 401(k) is a tax-deferred retirement plan that allows you to contribute a portion of your salary before taxes. The money is then invested according to your selections and remains tax deferred. The price is that you cannot withdraw any of the money until the year you turn 59 and a half, without paying a penalty. Then, when you are retired and begin withdrawing the money, it will be taxable income, presumably at a lower rate.
But what can be even more significant is that many employers offer matching contributions, up to a certain percentage of your salary.
How credit scores predict what you will buy next
Let’s say your annual salary is $75,000. Your employer offers, for example, a match of up to 5%. (In my own experience, the lowest employer match I was ever offered was 3%, and the highest was 8%.)
In this example, if you were to contribute 5% of your salary, or $3,750 a year, to your 401(k) account, your employer would also contribute $3,750 a year. Contributions are typically made every pay period. The bottom line is: Each of your contributions would earn an immediate 100% return — a doubling of your initial investment. You will need to check to see how long it takes for the employer’s contribution to be “vested.” This means you may lose recent matching contributions if you change employers. For some companies, after an initial vesting period, all employer matching contributions are immediately vested.
Chances are, especially if your career has decades to go, that your 401(k) money will be invested in stock mutual funds, including low-priced index funds. That instant 100% return provides plenty of downside protection. Yes, it’s a tall order to sock away 5% of your gross pay. It may feel as if you took a painful pay cut. But watch your account grow, and you will be amazed.
How about a New Year’s resolution, each year?
Despite that wonderful 100% return if you contribute what your employer is willing to match, you should consider, over time, working your way up to making maximum annual contributions to your 401(k).
The operative word here is “consider.” Maxing out your 401(k) contribution isn’t for everybody. Your salary might not be high enough. Or you might have another opportunity to invest money outside your 401(k) to make even higher returns. Maybe so, but if you do not contribute to a retirement account, will you really make other investments, or will you simply spend the money on a larger house, a better car or more toys?
Think about it.
The maximum annual 401(k) contribution is $18,000 a year, and you can contribute an additional $6,000 a year if you are at least 50 years old. Here’s more information from the IRS.
That’s a lot of money, especially for our example of a $75,000 salary, for which $18,000 in contributions would amount to 24%.
But you can start small. Let’s say that, in our example, you begin by contributing 5% a year to take full advantage of the match. Over the years, as your salary increases or you get promoted or move on to higher-paying jobs, you might slowly increase your annual contributions. How about increasing it by at least 1% per year? Eventually you will be maxing out your contributions, without feeing too much pain in any one year.
Here’s another example, this time with a $100,000 annual salary. You still receive a 5% match for your contributions, but you also max them out at $18,000 a year.
The employer’s 5% match comes to 28% of your annual contribution. That is a wonderful instant return on your investment, and a very high level of downside protection, if the stock market has a bad run.
And here’s a bit more icing on the cake. Check out this S&P 500 SPX, -0.46% chart:
As you can see, the three-year trend is favorable, despite the occasional decline. Decreases may be worrisome, especially if you look at the stock market’s results every day. But your 401(k) contributions would continue to be made as long as your employer pays you, so you would have paid lower prices and beaten the market’s overall return.