A 401(k) is a retirement savings plan offered by most employers to employees. It lets employees save and invest part of their paycheck before taxes are taken out. The max an employee can contribute to a 401(k) will now be $18,500 starting in 2018, a nice little bump up from the previous max of $18,000.
I want to illustrate how much a 401(k) can impact overall savings rate, using my last two paychecks as an example.
This month I finally became eligible to contribute to my 401(k) plan at my new job and I elected to contribute $650 of my total paycheck to it. To see just how much of a difference this makes, here is my paycheck from two weeks ago without any 401(k) contribution:
|My Paycheck Without Any 401(k) Contribution|
|Total Amount of Gross Pay I Kept||$2,264 (72.5% of gross pay)|
My total gross pay was $3,120, but after paying Social Security, Medicare, and all the different levels of federal, state, and local taxes, I was left with $2,264. I kept 72.5% of my total gross pay. It’s pretty incredible to see that over a fourth of my time spent working in my cubicle was solely me working to pay taxes.
Now here is my most recent paycheck with a 401(k) contribution:
|My Paycheck With a 401(k) Contribution|
|Total Amount of Gross Pay I Kept||$2,452 (78.5% of gross pay)|
By contributing $650 from my two-week paycheck to my 401(k) plan, I was able to significantly reduce my federal and state taxes and keep 78.5% of my total gross pay. None of the $650 I saved was taxed at all. It simply bypassed the tax man altogether and jumped safely into my S&P 500 fund in my 401(k) plan.
Now let’s visualize the dramatic difference between contributing $650 each paycheck compared to not contributing at all.
Here’s what my paychecks look like if I contribute $0 to my 401(k) plan every two weeks:
And if I keep this pattern up for one year:
I would retain a total of $58,864.
Here’s what my paychecks look like if I contribute $650 to my 401(k) plan every two weeks:
And if I keep up this pattern for a year:
I would retain a total of $63,752. That’s a difference of $4,888.
Maybe $4,888 doesn’t sound like much, but here’s what an extra $4,888 can become if it’s invested for 20 years at a 7% interest rate:
That’s over $214,000 in 20 years.
If you’re looking to improve your financial situation, increase your savings rate, and pay less in taxes, look for ways to contribute more to your 401(k) plan each year. The long-term impact of steady savings is incredible.
Happy saving! 🙂
Zach is the author behind Four Pillar Freedom, a blog that teaches you how to build wealth and gain freedom in life.
Zach's favorite free financial tool he's been using since 2015 to manage his net worth is Personal Capital. Each month he uses their free Investment Checkup tool and Retirement Planner to track his investments and ensure that he's on the fast track to financial freedom.
Although the bulk of his net worth is invested in index funds, his favorite place to invest in individual stocks is M1 Finance, a site that allows you to build a custom portfolio of stocks for free.
His favorite way to save money each month on his recurring bills is by using Trim, a free financial app that negotiates lower cable, internet, and phone bills with any provider on your behalf.
His favorite micro-investing app is Acorns, a free financial app that takes just 5 minutes to set up and allows you to invest your spare change in a diversified portfolio.
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