With traditional pensions on the decline and Social Security raising concerns, it’s more important than ever to maximize every retirement savings opportunity. Missing out on the full employer contribution is a mistake in the long run.
We’re all encouraged to put money away for retirement. With traditional pensions on the decline and Social Security raising concerns, it’s more important than ever to capitalize on any opportunity. A key component of anyone’s retirement strategy should be an employer 401(k) plan. You can “pay yourself first” using pre-tax contributions and compound interest to great advantage.
Despite this, nearly half of workers in any given year don’t participate in a workplace retirement plan (source: Pension Rights Center). Even among those who do participate, contributions often fall short of what is necessary to ensure a satisfactory replacement income upon retirement. The money you set aside today will determine your comfort as a retiree.
One key participant incentive is the employer matching contribution. The company agrees to match some portion of each dollar the employee contributes up to a maximum amount, usually 4%-6% of salary.
Whether you view it as “free money” or earned wages, missing out on the full employer contribution is a mistake in the long run. Yet studies have continued to show that many workers are giving up hundreds of dollars each year by failing to max out their employer match.
How much can it hurt? Let’s examine the effect on two workers over the course of only 10 years.
Employer Matching Contributions: A Comparison
Both of our fictitious employees are making the same amount ($50,000) and starting their accounts with a zero balance. Their company offers a match of 50 cents on the dollar up to 5% of salary (a maximum of $2,500). Bob isn’t maxing out his contribution, while Linda gets the full match.
Bob
Bob contributes 3% of his pretax income, or $125 a month. His employer matches half of that for $62.50 per month. That gives Bob $2,250 in annual contributions. At an average investment return of 7%, his account grows as follows:
Year 1: $2,328.75
Year 5: $13,392.03
Year 10: $32,175.05
While that’s an improvement over the $21,450.04 he’d have in a decade without the match at all, Bob is going to be well behind Linda by that time.
Linda
Meanwhile, Linda maxed out her company match. That’s $208.33 every month, with the company kicking in an additional $104.17. That totals $312.50 each month, or $3,750 annually. At the same 7% rate, Linda’s account balance looks significantly better:
Year 1: $3,881.25
Year 5: $22,320.06
Year 10: $53,625.09
After a decade, Linda is significantly ahead of Bob by $21,449.95. That’s two thirds of Bob’s entire account balance.
Granted, neither Bob nor Linda are saving enough in general. If their colleague Jack was saving the minimum recommended 10% of his gross income under the same exact circumstances, his ending balance would be $89,375.15 at that point—more than Bob and Linda combined.
That is the simplest example of employee matching combined with compound interest. It’s not taking into account any effects of raises, bonuses, or deferred tax benefits over the course of that decade. I used salary figures near the U.S. median to illustrate how the average worker needs to think about retirement savings.
Defined benefit pensions are largely extinct. Employees overwhelmingly bear the brunt of funding their own retirement. Matching contributions are crucial to that effort. Don’t leave that money behind. Take the advantage when it’s there for you to prepare for a happy retirement.