I love basketball because it allows me to make analogies and/or parallels to finances. Basketball has something called the 3 second rule which does not allow players to stand close to the basket without movement. The reason this rule exists is so that taller players cannot abuse their height and score relentlessly without movement. So, this makes taller players play more efficient whenever they are in the post area.
Whenever we see limits set to something, it can be an indicator that if that limit were not there, people would probably abuse the situation because of its value add. That is how we should look at our 401(k); this investment option has a limit associated with it, because if not, wise investors would most likely abuse the benefits it brings. What are those benefits?
Tax Advantages
This is where you see a lot of advantages using your 401(k) as an investment vehicle because no matter your income level, you will find a benefit. Within your 401(k) plan, you can generally make one of two options: pretax or Roth. They are both great but are taxed differently:
Pre Tax: Whatever you contribute will be deducted from your current income, so this will lower your tax liability for that year. But as it grows you will be taxed on that growth whenever you pull that money out.
Roth Contributions: You pay taxes on your contribution, but as this money grows you do not have to pay taxes on the growth of this money. A colleague of mine uses the analogy of would you rather pay taxes on the seed or pay taxes on the tree.
People tend to lean towards making pretax contributions because they reach a place in their career where they feel like they are paying a lot in taxes, and these contributions can help mitigate that tax liability. In addition, some might think when the funds become available at age 59 ½, and they are retired with no income source, they will now be in a lower tax bracket, so the taxes will not be as much.
For Roth contributions, the benefit is you have decades of growth on your investment, knowing it will not be taxed whenever you pull from the distributions. This gives you a lot of flexibility with purchasing power in retirement, because this bucket of money has not only grown and been a great hedge for inflation, but you can use these funds for large purchases without the worry of taking out additional funds to cover the tax burden. A colleague uses this analogy, “Would you rather pay taxes on the seed or pay taxes on the tree?”.
Free Money
A lot of companies will match a percentage of employee contributions. In simple math, let’s say an employee gets a 5% match up to 5k a year by their employer. If you continue receiving that match for 20 years with a 7% rate of return, that would amount to over $200,000 dollars just from your employers matching. This doesn’t take into consideration the exposure to growth.
Behaviorally
Let's be honest with ourselves, we aren’t perfect, and we don’t always make the right decisions, and that's okay. Drake continues to make songs about his exes and should probably move on, but oh well. Sometimes having buckets of money we cannot touch without penalty helps encourage us to let it continue to grow. This is why I automatically have funds deposited directly into savings every time I get paid!
Disclosure:
This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.