Milestone 2: Take Advantage of Your Employer Match
At this point you should have completed your budget, saved at least $1,000 in cash, and are ready to move on to Milestone #2 on the Next Dollar Roadmap: Take Advantage of Your Employer Match.
- Starting Point: Creating Your First Budget
- Milestone 1: The Uh-Oh Fund
- Milestone 2: Take Advantage of Your Employer Match
- Milestone 3: Pay Off Toxic Debt
- Milestone 4: Fully Funded Emergency Fund
- Milestone 5: Save 15%-25% of Your Income in Tax-Advantaged Retirement Accounts
- Milestone 6: Save for Flexibility in Bridge Accounts
- Milestone 7: Prefund Kids’ Expenses
- Milestone 8: Pay Off Remaining Debt
- Milestone 9: Total Financial Independence
Before we get started, I want to clarify that we’re not proposing you ignore your outstanding debts completely while pursuing your employer match.
In all likelihood, you have minimum payments that must be made to service your debts and keep you out of default.
Be sure you are at least meeting those minimum requirements before directing your next dollars to Milestone 2.
With that said, let’s look at why you should take advantage of any employer match available to you and where to get your hands on this free money.
1) Matching dollars are too powerful to pass up.
The reason we’ve put this milestone ahead of paying down outstanding debts (Milestone #3) is the value of an employer match is too good to pass up.
Effectively, the rate of return on the dollars from your employer match is 100% (assuming the employer match is dollar for dollar).
The all-time average rate of return for the S&P 500 is 10.67%. Real estate: just over 10%. Reasonably common or safe investments only go down in return from there.
There just aren’t many places you can invest and capture a return like that. Actually, I can’t think of any that are guaranteed.
And odds are, your employer provides a match of some sort. In 2022, some 98% of employers provided some sort of employer match in their 401(k) plans.
2) Even bad debts don’t outweigh the benefit of the match.
Even if the available employer match isn’t 100% if it’s higher than the interest on your outstanding debts you will likely benefit from taking advantage of it.
It’s unlikely you have any debts that have the same or higher interest rate working against you.
Even the worst credit card I know of (that charges a little over 36% interest) would only provide one-third of the benefit as your employer’s dollar-for-dollar match if you decided to pay it off first.
If you have an outstanding payday loan or a debt to a 300-plus pound loan shark named “Tiny” you might want to bump it ahead of your employer match in priority, but those are the only cases I can think of.
3) Let your boss boost your bucks with the match!
To drive the point home further, a single dollar today is potentially worth over $45 in 40 years (assuming a 10% rate of return).
With a dollar-for-dollar employer match, that same dollar you contributed is worth over $90!
In short, the employer matching programs offered by your company are one of the quickest and easiest ways to supercharge your retirement savings and boost your net worth.
4) Tiiiii-iiiii-i-iiime is on your side, yes it is.
Finally, for those of you who are early in life and your careers, you have something no one else can get: time.
The most important component in wealth building, aside from money itself, is time. Allow me to illustrate.
Calvin Compounder and his older colleague Larry Latetoparty have decided to get their investing lives in order and begin contributing to their company’s 401(k) plan.
Calvin is 25 and his pal Larry is 45. They have the same job and salary ($50,000), both plan to retire at 65, and both will contribute 6% of their salary to their company 401(k) to take advantage of their employer’s dollar-for-dollar match.
Assuming they generate an average return of 10%, let’s look at the forecast for Calvin and Larry’s plans, respectively.
At the end of 40 years, when Calvin turns 65 he’ll have $271,555.53 from his annual contribution of $3,000.
Larry on the other hand only had 20 years for his balance to grow. As a result, his 401(k) is worth only $40,365.00 when he reaches 65. Sad.
This illustrates the power of compounding interest.
This leads me to one of my favorite quotes: “Time isn’t everything, it’s the only thing.” – Thomas Faux Landry
Okay, maybe time isn’t the only thing, but it sounds important, right? Besides, it clearly makes one heck of a difference. You have no time to waste. Start getting your employer matching bucks today!
Where to Get Those Matching Dollars?
There are a couple of common ways your employer might match dollars or provide financial incentives you should prioritize. Let’s go over some of those now.
The 401(k)
Named after the IRS code section covering this retirement plan type, a 401(k) is a defined contribution, employer-sponsored personal savings account.
In other words, it’s a retirement plan set up by employers into which employees may elect to have a certain percentage of their income directed.
When enrolling you can elect to have a certain portion of your paycheck placed into the account. Those funds are then available to invest in a variety of options like money markets, bonds, stocks and equities, target date funds, or some combination of these.
The benefit for you is contributions to a traditional 401(k) are placed into the account before they are taxed.
This leaves more principal to invest and grow, as well as postponing any taxes you’d owe on that income until later in life.
For example, if you’re in the 22% tax bracket, each $100 you put into the 401(k) avoids $22 of income taxes until you withdraw it.
Even the least mathematically gifted among us can understand that the return on $100 invested would be more than the return on an investment of only $78.
But, about those delayed taxes…
When you withdraw your 401(k) savings you’ll pay income tax on the whole withdrawal, both principal and interest. That’s because those dollars have never been taxed.
It’s not all bad though. The 401(k) provides an opportunity to participate in a little tax arbitrage if you’ll be in a lower tax bracket when you retire.
Using the example above, let’s say you find yourself in the 12% tax bracket at retirement. You’ll only pay $12 out of that $100 instead of the $22 you would have paid in the 22% bracket.
Imagine if that 10% tax savings could be realized for your entire 401(k) and you quickly understand how beneficial this delayed taxation can be for you.
The current average 401(k) balance at 65 years old is about $280,000. Ten percent of that is $28,000!
Now, there are some rules and limitations on 401(k)’s. For example, If you withdraw funds from the account before you turn 59.5 you’ll pay a hefty 10% penalty on your withdrawal in addition to the income taxes you’ll owe.
There are exceptions to this. If you retire, quit, get fired, or are laid off you may be able to withdraw as early as 55 penalty-free. See the “rule of 55” for more information. See this post for other early withdrawal options.
You are also limited to tax-deferred contributions of $20,500 per calendar year ($27,000 if 50 or older).
This amount does not include your employer match, so you can contribute the max and still receive your employer match in addition to your tax-deferred deposits.
Be sure to carefully read your 401(k) plan documents to understand the matching component. If you front-load your deposits early in the year your employer may not continue to deposit your employer match to the end of the year.
In addition to your tax-deferred contributions, if your plan allows you can contribute another $40,500 (catch-up provisions available if over 50) of after-tax dollars into your 401(k) in 2022. Only the earnings on these dollars would be taxed upon withdrawal.
Another exciting possibility is the use of the Backdoor Roth IRA if your employer allows in-service distributions. If you have the money, you should consider this strategy as it can be a boon for your financial success.
Your employer also receives a tax break for the matching portion they put into your account. Most plans (98% of them) have a dollar-for-dollar employer match, but other plans may match at a lower percentage or even through the use of profit-sharing dollars.
On average, employers offered to match up to 6% of employee contributions in 2022. About 68% of Americans have access to a 401(k) plan that includes some form of an employer match, but 17% of those with access don’t contribute at all.
Another 12% don’t contribute enough to fully utilize their employer match. That’s a lot of free money left on the table. Don’t be one of these people. Get your free money!
457’s and 403(b)’s
You may find that your employer offers 457 or 403(b) plans instead of a 401(k).
In many cases, employers do not match contributions in these plans, but there are exceptions. You should take advantage of any employer matching dollars you can get here too.
457s and 403(b)s have their own nuances you should familiarize yourself with if you have one of these plans. 457s are an especially useful type of retirement plan for really loading up on savings and for early retirement.
We’ll discuss these more in Milestone 5.
Roth vs Traditional
Some 86% percent of 401(k) plans offer a Roth option.
Originally only available as an IRA, a Roth 401(k) allows the account holder to pay taxes before contributions are made to the account.
However, in the case of a Roth, all distributions, including principal and growth, can be made tax-free.
In summary, a Roth is taxed before the money is placed into the account while a traditional plan is taxed as the money is withdrawn from the account.
Mathematically, if your tax bracket remains unchanged and your rate of return is equal, the end result for either plan is the same.
Go do the math if you want, but it’s true. We’ll walk through an example at Milestone 5.
What you really want to consider is when you will have the lower tax bracket.
If you think you will be taxed at a higher rate in retirement because you’ll have so much money saved it’ll be falling out of your deep-dish pockets, then the Roth is for you, my friend.
On the other hand, if you have a high income currently and find yourself in a high tax bracket, you will likely do better to take the traditional route and withdraw or convert your dollars strategically in retirement.
There is an endless amount of debate on Roth vs. traditional which I am only going to add fuel to here.
Ultimately, you need to make the best choice you can based on the information you have available and the goals you have financially.
Personally, I go Roth as long as I’m in the 24% federal bracket or lower.
My own belief is that taxes are historically pretty low right now and the government doesn’t seem interested in spending any less.
In other words, I think taxes are likely to increase in the future, so I prefer to pay now at the tax rates I know today and be done with it. I may not be right, but no one will know until I start withdrawing funds.
Not only that, but we’ve been saving aggressively since our mid-20s. There’s a good chance our income will increase when we retire.
HSA/HRA/FSA
Let’s start by identifying and defining each of these:
Health Savings Account (HSA)
This is an awesome savings plan that has tax advantages going in, growing, and coming out if used for healthcare expenses (that’s triple tax savings!).
They also can sidestep Social Security, unemployment (FUTA), and Medicare taxes going in if your employer deposits the funds directly into your HSA.
HSA’s are unique in several ways, but mostly because they have the option to invest the account funds in securities as you might in your 401(k) or IRA. These funds can grow for years or be used for medical expenses at any time.
You can also use the HSA as another retirement account. Any funds used in retirement for non-healthcare expenses are treated similarly to traditional IRA or 401(k) funds.
Inherited HSAs are treated like taxable income to the heir in the year you pass, so be thoughtful about how you hand these down.
HSAs are only available if you are covered by a high deductible health plan (HDHP) and can be obtained outside your employer’s plan, but you won’t get any of the payroll tax breaks going in, nor will your employer be able to place matching funds into the account.
Flexible Spending Account (FSA)
An FSA is an account generally offered by employers that can be pre-loaded annually for expected healthcare needs in the upcoming calendar year.
The contributions are tax-free and can only be used for medical expenses. FSAs do not provide an investment option like the HSA.
Usually, FSA funds that are not used by the end of the year are forfeited to the plan administrator, but some plans allow the funds to roll over.
You are not required to have an HDHP to use an FSA.
For a thorough comparison of the HSA vs FSA decision, check out this post.
Health Reimbursement Arrangements (HRA)
HRA’s are health spending accounts provided and owned by an employer.
Like an FSA, there is no option to invest HRA funds for long-term growth. However, HRA funds generally are carried over from year to year and made available to employees even after they retire from their company.
HRA’s are a bit of a retainage tool in that most employers will force you to forfeit any remaining balances if you sever employment prior to retirement.
You are not required to have an HDHP to use an HRA.
So, what do health accounts have to do with employer matching dollars?
In many cases, employers will incentivize employees to participate in various health plans and to save for their own future health needs by contributing an employer match or even an annual gift to these types of accounts.
In other cases, employers may use matching or gifted funds to entice employees to exercise more or regularly visit their physician.
For example, at the megacorp I work for I’m given $1,200/year in my HSA just for using an HDHP. Additionally, I can earn up to another $740 by reporting healthy habits like exercising, going to see the doctor, or maintaining a healthy body mass index (BMI).
Regardless of the employer’s motive, if they offer free money combined with your health coverage you might as well accept it.
Wrap-Up
So, there you have it. There are lots of free dollars out there and hopefully, you’re in a position to take advantage of it. If so, grabbing those employer-matching funds is a no-brainer and can be a real boon to your financial success.
You might be asking yourself if you should go ahead and contribute above and beyond the amount necessary to receive your maximum employer match.
The answer is, not yet. That’s coming up at Milestone #5. For now, just contribute what your employer will counter with a contribution of their own.
Next stop, Milestone 3: Pay Off Toxic Debt
