The Retirement Saver’s Secret (as in “Under Appreciated”) Weapon
In last week’s article, we explained how tax-deferred savings represents the first of four gears that drive retirement plan success. In fact, it may be the most powerful driver in the entire set of gears. For some reason, though, the standard method used to encourage this type of savings falls flat with many employees. Why is this such a problem? More important, do you know there’s a much more sexier way to entice employees to save in retirement plans?
Like driving, getting into first gear is often the highest (and hardest) hurdle retirement savers face. In this manner, tax-deferred savings is both the greatest secret weapon as well as the most under appreciated for retirement savers. Like beginning an exercise regime, many people find it hard to even start saving. But, as with exercise, once you develop the habit of saving, it’s much easier to continue.
We all know what they say about exercise. It takes time to see the effect, but over that time period, you’ll feel a lot better. In a similar manner, the most cited reason for tax-deferred savings also focuses on the long term.
“By saving in a tax deferred vehicle, the investor is able to prolong the time in which he or she has to pay the taxes on the money saved as well as the gains,” says Rob Clark, Partner at MPC Wealth Management in Orlando, Florida. “More simply, it gives savers the opportunity to have more money working during the time of saving, eventually paying the taxes when the money is needed for retirement.”
There’s nothing wrong with this explanation. It is both true and accurate. But, alas, it’s about as exciting as watching paint dry. If only there was a more invigorating reason for employees to save. Then they would have a greater interest in the wonders of pre-tax savings. Well, dear reader, we’ve just happened on just such a reason. Why it isn’t used more often we cannot explain, but here it is nonetheless.
Unlike exercise, tax deferred savings can offer immediate gratification.
It can, in effect, give you an instant raise in net take-home pay.
Pete Marriott, Managing Director at Trinity Retirement Solutions, LLC in Charlotte, North Carolina, says, “It costs less to save in a tax-deferred account than in an after tax account. That cost is about $0.70 on the dollar to get $1.00 into the account.”
“For example,” says Dan Palmer, a financial advisor for Rehmann Financial Group in Fort Wayne, Indiana, “a $20 contribution does not cost the employee $20. Because it is pretax it only costs them $15 in take home pay.”
Here’s how it works. Let’s say you’re a single taxpayer with a $25,000 annual salary, getting paid every two weeks and with the standard deduction and exemption amounts. If you save 5% in a tax-deferred plan, about $48 dollars is taken out of your biweekly paycheck. However, since this $48 is taken out pre-tax, your pay is reduced only by roughly $41. Over the course of a year, your annual take-home net, as a result of this tax savings, is $188. If you’re a spendthrift, that’s an extra latte a week. If you’re like me, that a couple dollars more you can pump into your savings account.
Now, if you think this is good, imagine if you saved more. Your tax savings would be greater; therefore, your take-home net would be greater. Using the same example above, if this person deferred 8% of his salary, his net increase in take-home pay would be $300. If he deferred 10%, it’s like giving himself a raise of $563 per year! That’s a lot of lattes.
Many plan sponsors struggle to convince employees to save in their 401k plans. They hire professionals to bring out the charts showing how such savings can, over time, grow to impressive sizes. Despite the veracity of these statements, the alluring colors of the graphics and the fact an experienced professional is often the one stating these truism, the pitch fails to get the employees to act.
The problems lies in the unfortunate reality of behavioral economics – a bird in the hand is worth two in the bush. People would rather get an immediate reward than a deferred reward worth twice as much. If this is the case, then give them the immediate reward. Tell them the truth. Tell them, by saving in a tax-deferred retirement plan, they can give themselves an immediate raise.
And the more they save, the bigger the raise.
After all, everyone wants a raise, don’t they?
But wait! There’s more! If you think giving yourself a raise is a good idea, what do you think about getting paid more for giving yourself a raise? We’ll discuss that in the next chapter.
Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on how to create an investment policy statement that defines a set of menu options consistent with the concepts outlined here.