At Least That’s What One Economist Thinks… Until Then, Have You Or Will You Take Advantage Of It
Occasionally, someone pens an article that seems farfetched on the surface but makes sense when given some thought. Something has to be done to shore up social security in the coming decades. So, this particular author suggested modifying the traditional 401(k) by eliminating the massive tax breaks given to participants who contribute on a before-tax basis.
It's not a terrible idea, but apparently, it has been floated in the past. Will it happen this time around? Who knows? If it does, we will all adjust accordingly, and if it doesn’t, maybe we will better appreciate the gift that is the 401(k).
I want to highlight this in this blog post… When the Government gives us an incentive (e.g., tax savings), it is generally a wise idea to do so, as they are trying their best to enrich our financial lives.
Have you ever heard of the mortgage deduction? Why do you think it exists? The powers that be didn’t create this tax benefit because they think it’s cool for people to be homeowners. No, they know homeownership is 1) A great way to build equity, 2) Creates a sense of pride and peace of mind for most people, and 3) Helps drive our economy via new home construction and the continued maintenance required as homes age. All of this is good, and participating is in your best interest.
How about the child tax credit? Do you know about this? Again, the folks in DC learned a long time ago that encouraging family growth is not a good thing but a great thing! If you don’t believe me, take a gander at the fallout in China with their polar opposite idea. They are now paying the price for the ill-fated decades-long one-child policy. In this great Country, you’d never see such a draconian policy. You see the opposite!
So, our Government clearly wants us to own a home and fill it with children! In addition, for the past 40 years or so, they have wanted us to take responsibility for the lion’s share of our retirement, as the writing on the wall has been there for a while that social security in its current form will not exist in the long term (at least not without some help). So, here comes the 401(k)!!!
This might be the clearest signal our DC friends wanted us to do something because the tax incentive was so magnificent! Not only can you stuff $22,500 or $30,000 away a year (depending on how many times you’ve circled the sun), but the investments in your account grow tax-free, and your employer is incentivized to add even more money. The tax savings are outlandish!! Maybe too outlandish!
The chart below represents a tax-deferred account (a 401(k)) and a non-tax-deferred account. All the variables are the same except that the tax-deferred account holder invests their tax savings every year, and the non-tax-deferred account holder pays a small percentage in capital gains taxes every year.
After investing $10,000 annually and earning an average annual return of 9% for 25 years, the blue guy (tax-deferred) has an account value over $350,000 greater than the orange guy (non-tax deferred)—nearly 45% higher!
You don’t need to believe my hyperbole. But if the author referenced at the outset is correct, well, we don’t even need the above chart to know how great a 401(k) was/is. The Government just told you by taking it away. The pundits say the problem is that only rich to wealthy folks are taking advantage of the 401(k) meaningfully (i.e., maxing it out). There is a lot of truth to this.
The moral of the story: When Uncle Sam encourages us to do something via tax incentives, don’t ask questions—just do it! There are legions of folks who have stayed the course and are now known as 401(k) millionaires. If you are already on that path, congratulations. If not, there is no time like the present.
Cheers!
Marcus