Even in his prime, Warren Buffett couldn’t consistently deliver 46% returns year in and year out. The sage of Omaha is good…but not that good. (Ok, there was a stretch in the 1960s when he really did generate those kinds of returns, but we won’t split hairs.)
Amazingly enough, those kinds of returns are offered to the vast majority of employed Americans. And even better, they are offered with absolutely no market risk…or any risk at all, for that matter.
Today we’re going to take an unconventional look at that most conventional of investment vehicles, the 401k plan.
Most people look at a 401k plan and see a boring collection of mediocre mutual funds. And unfortunately, that is often true. But today, I’m not going to tell you what mutual fund to buy, nor am I going to give some wonky “guaranteed” trading strategy. Instead, I want to dig into the nuts and bolts of how 401k plans work, and show you exactly what I mean when I say that 46% risk-free returns are possible.
It comes down to two important things:
- Employer matching
- Tax savings
Let’s dig into matching. Not all employers offer matching, and some employers are more generous than others. But the tax code—and a desire to maintain a happy workforce—incentivize employers to contribute to your 401k plan on your behalf. A common matching level these days is 6%.
Now let’s consider taxes. Let’s say you had a fantastic year and you find yourself in the highest marginal tax bracket of 39.6%. Every dollar you divert into your 401k plan avoids this taxation…which means that you effectively just “earned” nearly 40% simply by not having to pay taxes. Between tax savings and matching, you just hit that 46% return level, and I haven’t said a word about investment returns. I’m assuming the funds went into a money market fund paying 0% interest.
Ok, I realize there are a few problems with my argument. Tax savings and matching are not technically “returns.” And obviously, not too many Americans are in the top marginal tax bracket.
But the takeaway is this: Your investment returns matter, but other considerations–such as tax effects and matching–can actually matter a lot more to your effective returns. Simply shifting your investments from one type of account to another can make a major difference to your wealth.
Before you do anything else with your money, you should absolutely max out your 401k every year, or at least come as close as you can given your living expenses. Yes, the mutual funds available might be cheesy. Big deal. You’re starting out as much as 46% ahead simply by showing up.
In 2015, you can put $18,000 of your own money into a 401k plan, and this does not include employer matching. If you are aged 50 or older, you can chip in an additional $6,000. Whether you are in the 39.6% bracket or the 15% bracket, the tax savings alone would make it worth your while to dump every penny you can into your 401k plan. Add in the free money from matching, and you’d be a fool not to take advantage of it.