401(k) Calculator

If you’ve thought for even a few minutes about saving for retirement, chances are you have some familiarity with the 401(k) savings plan. You probably know, for example, that a 401(k) is a type of “defined contribution plan,” and you are probably aware that it receives special tax treatment from the IRS. You may even remember some of the rules regarding early withdrawals and roll-overs - or maybe not.

For anyone who is building a retirement strategy that prominently features a 401(k), it’s important to have a deeper understanding of the plan, both its advantages and disadvantages. In what cases is it most useful? Are there hidden costs? And, most importantly, how does the dang thing work? Before we try to answer that question, however, let’s make sure we understand the basics.

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What Is a Defined Contribution Plan?

A defined contribution plan is any retirement plan to which an employee or employer regularly contributes some amount. Often, the employee chooses to send a fixed percentage of monthly income to the account, and these contributions are automatically withdrawn, directly from her paycheck - no effort required. The money that doesn't go to the employee's take-home pay gradually accumulates, the balance earns interest from investments, and by the time retirement rolls around, it’s grown into a substantial nest egg for the retiree. That’s the idea.

In a defined contribution plan (unlike in a defined benefit plan), there are no guarantees about the income you’ll receive in retirement. That doesn’t mean such plans can’t be just as effective, however, and employers often sweeten the deal by making contributions of their own, straight into your account.

Why Employers Offer 401(k)s

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In 1978, when the law authorizing the creation of the 401(k) was passed, employers commonly attracted and retained talent by offering a secure retirement through a pension (a type of a defined benefit plan). The 401(k) created an entirely new system, with more flexibility for both employer and employee. One of the ways it did so was by giving employers the option to “match” employee contributions.

Matching is a very transparent process: for every dollar you put into your 401(k), your employer also puts in a dollar, up to a certain amount or percentage of your income. There’s no mystery here. If your employer promises to match all 401(k) contributions up to 5% of your income, and you contribute that amount (5% of your income) every month, your employer will match you dollar for dollar, every month. It’s a win-win situation. You are doubling your money, and your employer is building a happy workforce.

A common example of such a matching agreement is for the employer to match 100% of all contributions up to 6% of an employee’s income. If you make $100,000 a year, your employer will match annual contributions up to $6,000. So if over the course of a year you contribute $6,000 to your 401(k), your employer will likewise contribute $6,000, and you get $12,000 total. Note that you can may be able to make contributions above 6%, but your employer won’t match those additional dollars. So, if you contribute $10,000 over the course of the year, your employer will only match the first $6,000. Still—that’s $6,000 extra into your account, an a 401(k) calculator can help you see how these matching contributions or larger yearly contributions can impact your retirement savings.

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Other Benefits of a 401(k)

Even for employers who do not offer any matching program, every employer with a 401(k) plan is responsible for administering the plan. That may seem like it’s no big deal, but it actually saves quite a bit of trouble for the employees. As an employee in a 401(k) plan, you don’t have to worry about the complicated rules and regulations that need to be followed, or about making arrangements with the funds in which you invest your money—your employer takes care of all of that for you. That’s quite a bit of saved paperwork.

At the same time, employees who participate in a 401(k) maintain control over their money. While employers provide a list of possible investment choices, most commonly different sorts of mutual funds, employees have quite a bit of freedom to decide their own strategy. Whether you are willing to take on a little more risk with your investments, or if you would rather play it safe, there’s probably an option for you.

401(k)s and Your Taxes

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Ah yes. Perhaps the greatest advantage of the 401(k) is that contributions to a 401(k) savings account are made pre-tax. When your employer sends out paychecks, the 6% (for example) of your income that you’ve decided to contribute to your 401(k) has already been withdrawn, before your employer has withheld anything for taxes. That leaves 6% less income to be taxed, and a lower overall tax bill.

By comparison, think about what happens when you put money in a bank account: your employee sends you a paycheck, but chops off around 30% of it to give to the IRS for withholding taxes. So for every dollar of pre-tax income, you can only drop 70 cents in your savings account. That’s a big difference!

Of course, keep in mind that income sent to your 401(k) is not tax exempt. Eventually, you will pay income taxes on it, but only when you withdraw it. If you don’t plan on doing so for 10, 20, or 30 years, that extra 30 cents has a long time to earn interest. That adds up.

So let’s use the 401(k) calculator to show you how. For example, let’s say you are 40 years old, and plan on retiring at the age of 67. That leaves 27 years for your current investments to gain value. Using the previous example, in which you make $100,000 per year, and your employer matches up to 6% of your income, you stand to earn over $10,000 more by putting your $6,000 in your 401(k) this year as opposed to a standard savings account—even if you assume both will garner the same 4% return rate.

Of course, a large part of that difference is a result of your employer’s matching funds. That extra $6,000 basically makes the calculation a no-brainer. Even without matching, the 401(k) can still make financial sense because of its tax benefits. Let’s go back to the 401(k) calculator to look at that same example—you make $100,000 and contribute $6,000 annually to your savings—but without any employer matching. Even in this case, you will still save an additional $2,000 just by using a 401(k).

Downsides to a 401(k)

A 401(k) really only makes sense as a retirement savings plan, and not as a general savings account. There’s a 10% penalty for withdrawals before your 60th birthday (well, before you turn 59.5 but how many people celebrate that milestone), and that’s on top of the regular income taxes you will have to pay. That penalty is enough to negate the other financial benefits of a 401(k), so any money you’d like to have ready access to should be saved somewhere else.

Secondly, investments made through a 401(k) often carry risk. As mentioned above, you will select from an array of investment choices with varying levels of risk, and with many of these, it is possible (albeit unlikely) that you may lose money over time. Keep that in mind when deciding how to allocate your retirement savings. It's important to also steer clear of 401(k) plans that charge high fees if you want to keep more of your money working for you.

In all, however, the 401(k) is a great option for you retirement savings. Given the tax advantages, the ease of use and the possibility of those additional matching funds, if your employer does offer a 401(k), you should definitely consider taking advantage of it. Try putting your specific numbers into a 401(k) calculator to see how it could work for you.