401(k) Analysis :: Wamhoff Financial & Accounting


401(k) Analysis

EFFECTS OF COMPOUNDING EARNINGS AND INVESTING PRUDENTLY

A 401(k) plan can be one of your best options for attaining long term financial security because it provides you with several important advantages. First, all contributions to (and earnings in) your 401(k) are tax deferred, meaning, you only pay taxes on contributions and earnings when the money is withdrawn. Because your contributions (and earnings) are not taxed until withdrawn from the account, there is the potential to grow your assets larger because you are investing money otherwise paid as tax. Second, many employers provide matching contributions to your 401(k) account. The combined result is a retirement savings plan you cannot afford to overlook.

Below we have prepared charts that illustrate the results of compounding earnings and the effect of investing prudently. For comparative purposes, we set the expected annual rate of return set at 6% in the first chart and at 8% in the second chart. In both of our illustrations, the employee begins contributing to the retirement plan at the age of 26 and retires 36 years later, at the age of 62. With an expected annual rate of return set at 6%, your 401(k) could be worth $647,523 after 36 years.

Assume your current goal is to contribute 10.00% of your annual salary of $40,000 to a 401(k). For simplicity, we kept your annual salary constant. So, we set your current contribution at $4,000.00 per year. The 2015 maximum annual contribution is $18,000. We started the account balance at $1,000. The expected annual rate of return was set at 6%.

This 401(k) plan also includes an employer match of 50.00% of your contributions, up to 6.00% of your annual salary. In this scenario, your employer contributes $1,200.00 per year. To receive your employer’s maximum match of $1,200.00, you should contribute at least 6.00% of your annual salary to your 401(k). Without your employer’s match, your ending 401(k) would be reduced to $499,974.

Feb 2016 Newsletter 401k graphic

In the first illustration, the combined employee/employer contribution was $187,200.00. The account value grew to $674,523.00 by the time the employee was 62 years old. This illustration demonstrates the potential benefits of investing, deferring tax and compounding earnings.

But, with an expected annual rate of return set at 8%, your 401(k) could be worth $1,030,556 after 36 years.

Assume your current goal remains at contributing 10.00% of your annual salary of $40,000 to a 401(k). Your current contribution remains $4,000.00 per year. We again started the account balance at $1,000, but the expected annual rate of return was set at 8%. In the second illustration, the combined employee/employer contribution remained at $187,200.00.

This 401(k) plan also includes an employer match of 50.00% of your contributions, up to 6.00% of your annual salary. In this scenario, your employer still contributes $1,200.00 per year. Without your employer’s match, your ending 401(k) would be reduced to $796,419.

The only modified figure from the first chart to the second chart is the annual rate of return, which was increased from 6% to 8%.

In the same timeframe, this account value grew to $1,030,556.00, or $383,033.00 more than in the first illustration.

Feb 2016 Newsletter 401k graphic 2

Comparatively speaking, this illustration demonstrates the benefits of investing prudently.