By Dr. Gary L. Deel
Faculty Director, Wallace E. Boston School of Business
and Dr. Karin Ford-Torres
Faculty Member, Wallace E. Boston School of Business
This is another article in an ongoing series on common wealth-building strategies. These articles are intended to share a general overview of conventional, commonly practiced financial methods from business school faculty members and are in no way intended to influence or impart financial/legal advice or actions to or on behalf of readers. Readers should always consult with an attorney or licensed financial advisor before making any financial decisions.
People are living longer and longer. With advances in medical technology, the average lifespan continues to rise. Currently, it is about 72 years for the world as a whole and almost 79 years if you live in the United States.
What does that mean? It means preparing for a longer retirement requires smart financial decisions today. Hopefully, your health will allow you to live a long and happy life. But you don’t want to make it all the way to retirement only to lament that you didn’t save enough money to support yourself in your golden years.
The Benefits of Employer-Sponsored Retirement Plans
Most financial advisors recommend taking advantage of employer-sponsored retirement plans if and when they are available to you. Obviously, not all employers have retirement plans. A lot of large companies do, but smaller businesses may not have the capital to offer such benefits. But if your employer does offer a plan, there are many benefits to consider.
The first is matching. Often, companies with sponsored retirement plans like 401(k)s offer a match on employee contributions up to a certain limit. This is by far one of the easiest and most common ways employees build wealth for retirement.
A typical example would be an employer that offers matching through its 401(k) benefits for full-time employees that includes a 100% match on the first 3% of total employee compensation contributed to the plan, and a 50% match on the next 2% of total employee compensation contributed to the plan. Additionally, employees who contribute to their 401(k) essentially defer paying income taxes for the portion they contributed annually, up to the maximum employee elective deferral, which is currently capped at $19,500 in 2021.
That last paragraph can be confusing to follow, so let’s break it down. Suppose, for the sake of an easy example, you work as a full-time employee and you make exactly $1,000 every week. Now, in a voluntary 401(k) program, you don’t have to contribute anything to the plan if you don’t want to.
But if you do contribute, your employee promises to match the first 3% at 100%. Three percent of your salary would be $30 per week, so if you’re willing to put that into your 401(k) investment account, then the employer will also put $30 into your investment account, meaning a total of $60 is invested. Congratulations — you just earned 100% interest on your money, instantly.
Now, if you’re willing to contribute an additional 2% of your salary to the plan each week, the employer will also match that additional 2%, but at a 50% match rate. So 2% of your salary means you would contribute $20, and the employer would match with 50% of that, or $10. Congratulations again – you just earned an instant 50% on that money.
What does this mean when all is said and done? It means if you elect to contribute 5% of your pay to your 401(k), you would allocate a total of $50 from each paycheck, and the employer would match $40 of that money.
What if your employer offers a retirement program but does not offer a match of any kind? This is actually pretty common, as, again, some employers just don’t have the financial ability to offer matching. If you work for such an employer, you should still consider participating in the employer’s retirement plan. This is because your contributions in such employer programs are still pre-tax.
Investing Pre-Tax Can Make a Difference in the Long Run
What does pre-tax mean? It means that the contributions you make to employer-sponsored retirement plans are allocated before income taxes are deducted from the money you make. To be clear, you will eventually have to pay taxes on the retirement income you contribute, but by investing pre-tax, you are able to take advantage of the whole pre-tax amount for maturity over time, which can really make a difference in the long run.
However, there may also be cases when paying taxes upfront, in what are known as Roth accounts, can make better financial sense. In the next article in the series, we’ll look at the differences between pre-tax and post-tax retirement investment strategies and why they really matter.
American Public University and American Military University offer academic programs in accounting and finance, which cover important financial discussions in depth. Readers who are considering expanding their knowledge and credentials in this field are encouraged to visit our program pages for more information.
About the Authors
Dr. Gary Deel is a Faculty Director with the Wallace E. Boston School of Business at American Public University. He holds a J.D. in Law and a Ph.D. in Hospitality/Business Management. Gary teaches human resources and employment law classes for American Public University, the University of Central Florida, Colorado State University and others.
Dr. Karin Ford-Torres is an Associate Professor with the Wallace E. Boston School of Business at American Public University. She holds a Ph.D. in Business Administration with a concentration in Advanced Accounting and Financial Management. Karin teaches accounting and finance courses for American Public University, Purdue University Global and Colorado State University-Global. She has 24 years of prior banking experience with Bank of America.