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The Impact of Maximizing 401(k) Contributions
#For Everyone    #WealthBuilding
When I was younger, working as an employee for large corporations, I used to think that the optimal amount for each person to put into their 401k is the level that maximizes the employer match.

That is wrong.  Oh, if I could only teach my younger self what I know now!

If the goal is wealth building, and if the strategy is to increase wealth building while paying the least in taxes, the optimal amount for each person to put into their 401k each year is the maximum amount allowed by law.

In 2019, the maximum amount allowed is $19,000 for each person in the United States, plus an additional $6,000 for anyone over the age of 50.  If you aren't putting this much into your 401k, you are paying too much in taxes, and you aren't maximizing the building of your net worth.

Of course, like most financial advice, this comes with some disclaimers and doesn't literally apply to everyone.  For this to be applicable, you need to be generating taxable income.  You need to have access to a 401k plan through employment or else your contributions are limited to the IRA maximum of $5,500 ($6,500 if you're over the age of 50).  Some individuals might have been putting money into their 401k for many years, and now use a deliberate strategy to save money through other investments.  Not every rule applies to every person.  However, this strategy applies to most Americans, both business owners and employees alike.  Additionally, the corner stone to any wealth building strategy is that you need to be able to live on less than your total income, to have some amount of money available towards wealth building - even if that just means adding a few bucks to your bank account each year.  If you spend every dollar you earn, there isn't anything left to put away for later.

Let's take a step back and look at the bigger picture.  There's a reason why the word "building" is part of in the commonly-used term "wealth building" - because for most of us, wealth needs to be built one dollar at a time.  The probability of receiving an unexpected cash windfall before retirement, that we didn't work for and build personally, is statistically very low.  Therefore, the wealth we will have is the wealth we must build ourselves.  

How The Math Works
To explain why it builds wealth to maximize 401k contributions, even if there is no match from the employer, let's start with the assumption that I earn $100,000/year in gross income, and that I am in the 30% marginal tax bracket for IRS + state combined.

Scenario 1
First, the base case scenario, with no 401k contribution.

● Gross income of $100,000/year.
● Let's assume that on $100,000 in gross income, I pay taxes of 20%, or $20,000.  That means I have $80,000/year of available, after-tax income income to live on.
● On the last $19,000 that I earn (the difference between earning $81,000 in gross income and $100,000 in net income), in this example we'll assume I'm paying 30% in taxes, or $5,700/year.

Even though I have $80,000/year of available, after-tax income, I can actually live on $65,000 a year, so I'm putting $15,000/year (the difference) towards wealth building because my bank account is growing by $1,250/mo.

Total Wealth Building: $15,000/year

Scenario 2
Now in Scenario 2: I am maximizing my legally allowed 401k contribution of $19,000/year (in 2019 - it goes up every year).

Therefore, my financial scenario look like this:

● Gross income of $100,000.
● 401k contributions of $19,000.   That does directly into my wealth building.
● Taxable income of $81,000.
● Taxes due are now $5,700 less than the amount in the first scenario, because 401k contributions reduce taxable income.  So taxes due are now ($20,000 less $5,700) = $14,300.
● Funds available to live on, after taxes: $81,000 minus $14,300 = $66,700

Total wealth building is now $19,000 added to my retirement account, plus the difference between my $66,700 from available funds and the $65,000 I need to live on: $1,700.  

Total wealth building: $20,700/year

Observations and Conclusions
In Scenario 2, I put away 38% more wealth than Scenario 1.  Big difference!  This strategy will add $5,700 to my wealth building every year. 

Maximizing the 401k, in this example, is like getting a 30% match from the IRS, with the trade off that I shouldn't touch the money until I reach a certain retirement age.  That's well worth it to get such a "match" contribution from the government.  A 401k is like having a savings account you can't really touch except for major emergencies.  Even if you were to just keep the funds in all cash, rather than fully invested, the same IRS match is still received.

If the employer offers a match on top of this, that's an added bonus.

Let's turn the tables and look at "the other side" of this - the cost of spending money rather than saving it.  In this example, the starting point for the analysis is that we assume I've been in Scenario 2 for three years, earning $100,000/year in income and putting $19,000/year into my 401k.

Now, I've decided I want to buy something expensive in the fourth year - like a trip to Europe or some new furniture. To make the purchase, I will need an additional $10,000 for spending that will reduce my 401k contributions down to $9,000 this year.

I contact my accountant and tell him, "I'm going to spend an additional $10,000 this year."  My accountant says "Okay, you're the boss - but I just want you to know, that's the equivalent of taking $13,000 out of your savings account because you're going to pay an additional $3,000 in taxes since you chose to spend $10,000."

You mean to spend $10,000 on a trip to Europe means I actually need to take $13,000 out of my savings?  That's outrageous!  Who would pay $13,000 out of their savings account to get $10,000 worth of spending benefit?!?

That's what each of us are doing every day when we are NOT maximizing our retirement contribution.  For every $10,000 we spend on expenses, we're paying an additional $3,000 in taxes because we choose to put that money towards things that are not recognized as tax deductions.  Every $10,000 we spend that isn't contributed into a 401k actually detracts from wealth building by $13,000, based on the numbers in this example.

Once I learned this, I started viewing my spending differently. Until I started maximizing my contributions, every time I was thinking about spending $100, I viewed the price as $130 (not to mention the compounding effect of returns, that at retirement $130 is likely to be worth much more!).  Every time I was thinking about spending $1,000, I viewed the price as $1,300.

There are many different paths and strategies to wealth building, and to minimizing taxes.  If you'd like to learn more about how this applies to your situation, the first step should be to talk with a tax expert about whether this strategy would work for you.  At The Numbers Edge, we aren't tax preparers, but we know what questions to ask and what strategies generally work well for a lot of people.  Feel free to ask us who we use for tax expertise if you don't have a trusted expert (Care@TheNumbersEdge.com).
  
  We love to help and answer questions.  Feel free to contact us at Care @ TheNumbersEdge.com 
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