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What Drives a 401k to Work So Well

July 02
01:40 2013

Before we get along too far on our journey to retirement success, let’s look at the basic building block to that success – the 401k plan. Rather than relive the history of this peculiar oddity in the U.S. Tax Code, let’s focus instead on what makes the 683804_19214434_muscle_car_stock_xchng_royalty_free_300401k vehicle work so well – and it has worked so well for so many people we can’t ignore it’s power.

In the simplest of words, the 401k plan can best be described as a souped-up IRA. It’s not quite the Shelby of retirement savings vehicles (some say that would be the SEP-IRA), but it does qualify as a muscle car. It performs formidably and, unlike the SEP-IRA, the 401k is almost universally available. So, what makes it tick? More importantly, what keeps this perpetual money-making machine in motion? Find the answers to these questions and you’ll discover why the 401k is such a powerful and effective tool for retirement savings.

If 401k investors want to achieve retirement success, they’ll want to fully understand the four primary cogs that drive this magical mechanism. Each of them can offer a key component to their own quest for retirement comfort. Some of them investors can control, some can’t be controlled. We’ll review them quickly here then delve into each of them in more detail in future articles.

For the purposes of this overview, and in keeping with our hot rod motif, let’s compare each of these factors as the gears that maximize the potential of all the horsepower the 401k has to offer.

First Gear – Pre-Tax Savings: This is the key motivating factor behind contributory retirement plans, whether they be a 401k or an IRA. It’s Uncle Sam’s way of saying, “Hey, you gotta learn to take care of yourself. Heck, I believe self-responsibility is so important, I’m willing to give you an incentive to get started and keep going.”

“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, CFP Partner of MPC Wealth Management in Orlando, Florida.

In addition to deferring taxes – and here’s the real kicker – pre-tax savings actually costs investors less than saving in an after tax account. In an odd way, employees can give themselves a “raise” (that is, in terms of their net take-home pay) merely by contributing to a pre-tax retirement vehicle. Financial professionals won’t go as far as to say savings in a tax deferred retirement plan is like creating money out of thin air, but, given its practical effects, there’s no harm in not discouraging 401k investors from believing that if they want to.

Second Gear – Tax Deferred Compounding: We all know the power of compounding. Well, mix in the tax-deferred element and we shift into a higher gear as this “money that appeared out of nowhere” all-of-the-sudden begins growing at an accelerating rate. By the way, to better understand the principle of compounding, think of it as acceleration. As a car accelerates, over time its speed increases. As money in a retirement plan compounds, over time it grows at a faster rate.

To be honest, many can get along fine just cruising in second gear, Quite frankly, this is where most folks stopped in the early days of the IRA. They’d save their $2,000 a year (that was the limit in the beginning) and plop it into a bank savings account or, if they were daring, a bank CD. They’d do this every year and watch their money grow – slowly, but safely.

With the advent of the 401k plan, retirement plans discovered two more gears, changing our savings vehicle of choice from a ’72 Pinto to a ’68 Mustang.

Third Gear – Company Match/Contributions: Unlike most IRAs, many 401k plans offer a company match or contribution. A company “match” means the company will match the employee’s contribution at a certain rate up to a maximum salary deferral. Most financial professionals will advise employees to contribute at least the amount that maximizes the company’s match. Indeed, academic research shows typical deferral percentages cluster around numbers divisible by 5 (i.e., 5%, 10%, 15%) UNLESS the maximum company match is a different number. For example, if the maximum company match is 6%, you’re more likely to find deferrals at 6% than 5%.

A company “contribution” means the company will contribute to the employee’s retirement account regardless whether the employee makes a contribution or doesn’t. While the purpose of the “match” is to provide additional incentives for employees to save, a “contribution” is often used when an employer seeks to meet minimum annual testing requirements to make sure the plan doesn’t treat highly paid employees more favorably.

In both cases, the money that comes from the company represents “free” money. Unlike the situation in the tax-deferred part above (i.e., “First Gear”), this really is money appearing out of thin air. Employees should grab it, all of it, as soon as they can. The company match/contribution shifts the employee’s savings growth up a notch as it begins to compound from day one.

Fourth Gear – Investment Returns: Finally, we have the highest gear. Unlike those early IRAs, which often found themselves in slow growth investments at banks, today’s 401k plans are supercharged with high-octane equity-based investment vehicles. While, unlike banks savings accounts, they do expose the investor to downside risk, over time they offer the potential for returns far exceeding those of bank savings accounts. This difference in returns – even if it were as small as 1% per yer – can have a dramatic impact in the long-term as compounding begins to pump up the value of those returns.

This last gear is usually what gets everyone exciting. After all, just as higher gears produce the fastest speeds for cars, one can find one’s retirement plan growing at a very high rate only because of its investments.

But here’s the ironic thing about investment returns: they don’t work if there’s little to no money in the account. Successful retirement investors have learned that relying on huge investment returns is a fool’s game. Indeed, there are no doubt plenty of retirement investors whose investments performed fantastically but who still were left with insufficient assets when it was time to retire. That’s because they focused too much on investments and not enough on the single factor that almost always can guarantee success.

Smart retirement investors focus on the right thing. We’ll talk about that “right” thing in next week’s article.

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.

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About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

7 Comments

  1. Shawn Patton
    Shawn Patton July 02, 20:51

    Great article and love the hot rod / gear analogy !

    Only thing I might suggest is to add “lower management fees” as the fourth gear, shifting “investment returns” to the 5th gear.

    As a Canadian consultant, working in jurisdictions that lack stringent fee/compensation disclosure requirements, fee/compensation reviews and consequent re-negotiation is a prime area where costs and risks can be reduced and hot rod and pick-up speed and avoid hitting the ditch/litigation.

  2. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author July 02, 21:04

    Shawn:

    Thanks for the kind words! Maybe a better analogy regarding management fees isn’t adding it as a gear but maybe they’re more like the price of gas?

  3. Dan McKeehan
    Dan McKeehan July 05, 11:57

    Great article to introduce readers to the 401 (k) concept. Love the ‘gas’ analogy in your comment to Shawn. Thanks Christopher!

  4. Andrew Simms
    Andrew Simms July 12, 13:12

    I love muscle cars so the analogy really worked for me! However, in my opinion, the only gear that diferentiates the 401(k) from any other investment account is the the employer contribution. The other 3 gears are pretty much the same inside or outside of a 401(k). If we only knew what future tax rates would be, then deferral could make a difference… Remember, taxed now or taxed later, as long as the tax rate is the same, there is no difference in outcome.

  5. Preston Neal
    Preston Neal August 02, 12:00

    Great article and love the analogy. I would one more element: cruise control. The ability to set-up automatic contributions takes advantage of dollar-cost averaging and helps build good habits.

  6. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author August 02, 13:59

    That’s a great addition!

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