Should You Max Out Your 401k This Year?

Ah, another fresh new year.  Its never too early to start thinking about your financial plans for the year.  I've already have heard several questions from others regarding their 401k plans this year.  Not all 401k plans have matching contributions.  Procter & Gamble (for USA) for example only offer a 401k program as a supplement to the Profit Sharing Plan and does not offer matching contributions.

So does it make sense to max the benefit?  This year, the max you can contribute to a 401k is ~$16,500 which is pretty substantial.  See the 401k vs IRA Comparison Chart Note that the IRAs (traditional + Roth) are independent from the 401k so you can contribute to each category independently. 

So what are the benefits of putting money into the 401k?  There is mainly one reason: contributions are pre-tax.  What this means is that it comes out of your gross income BEFORE taxes are taken off, essentially it means you do not pay taxes on that contribution.  For example, if you are in the 25% tax bracket ($35k-85k per yr), that $16,500 pre-tax contribution will avoid $4,125 in taxes.  This has 2 effects: first, it gives you a huge automatic boost in your account and second, it allows you to earn more on an absolute $ basis since your investment amount is larger.  This second effect compounds over time as well.

So how much benefit does this give you?  Lets work out the numbers below.


Scenario 1

401k is invested pre-tax at $16,500 per year.  Lets assume its a lump sum payment at beginning of the year just to simplify the math.  You invest that quantity for 3 yrs, we'll use the S&P 500 returns for 2009 (19.67%), 2010 (12.78%), and 2011 (0.0%) for this example.  Note that these returns are quite unusual but they're the most recent numbers and serve to exaggerate the effect a bit.  They also do not include dividends.

Year 1 - $16,500 invested at a gain of 19.67% yields a year end value of $19745 or a gain of nearly $3245.

Year 2 - $19,745 + $16,500 invested at beginning of the year at a gain of 12.78%.  You end the year with a value of $40877 for a gain of nearly $4600.

Year 3 - $40,877 + $16,500 invested at beginning of year at a gain of 0%.  You gain 0.

So at the end of these 3 years, you experience a gain of $7877 for a total account value of $57,377.  Not bad for a few years.

Scenario 2

So here's the other scenario, you instead choose to put the equivalent salary amount post-tax into a brokerage account.  For your $16,500 at a 25% tax rate, you end up at $12,375.  Lets use the same assumption above, deposit at beginning of year and using 2009-2011.

Year 1 - $12,375 invested at a gain of 19.67% yields a year end value of $14,809 or a gain of nearly $2434.


Year 2 - $14,809 + $12,375 invested at beginning of the year at a gain of 12.78%.  You end the year with a value of $30658 for a gain of nearly $3474.


Year 3 - $30,658 + $12,375 invested at beginning of year at a gain of 0%.  You gain 0.


So at the end of these 3 years, you experience a gain of $5908 for a total account value of $43,033.

Recap

The pre-tax contribution setup ended up with an account value of $57,377 (a $7877 gain) vs $43,033 (a $5908 gain) in a post-tax contribution.

That is effectively a free gain of $14,344 or a 33% increase both in total account value and in investment returns for the 401k vs non-401k.  In a world of 0.1% interest rates and generally poor returns, that is an astounding performance.  Even if the stock market returns an average 10% gain (very unlikely), that's still a 3 year leap.

And note that this is with absolutely no penalty or work for you if you have that money available.  In the world of economics, this is one of the few "free lunches" you'll ever find (in actuality, it comes at the expense of the government).

So what are some of the disadvantages with doing this? 

• You are limited to the investment options in the 401k.  As almost all 401k have a S&P500 index, this is likely what most people should pick seeing as how even most hedge funds fail to beat the S&P year after year.
• You can't contribute more than the $16,500 a year limit.  If you're looking to invest more, continue with Roth IRAs and brokerage accounts but try to max out this contribution first and foremost.
• The gains from this account will be taxed at your normal tax rate when you begin withdrawing.  This is mainly a negative if you expect to be in a higher tax bracket when you retire than you are now.  However, as you start with a higher initial investment amount, the benefits significantly overweigh the negatives.
• There are some penalties and restrictions associated with 401k withdrawals.  See the link above for more details.

While there are some limits, generally if you have the cash to put in it, you should do so.  The earlier, the better.

Keep checking this blog as I will do a walkthrough soon of the investment funds options currently being offered by JP Morgan retirement services for the P&G 401k plan to help you decide what to contribute into.