Why 401(k)s Are The Best Investments, Period

There are plenty of great investment options out there to choose from, but very few can compete with the advantages of a 401(k). When you add in employer matching to the equation, I believe 401(k)s become the best investment, period. Some other types of accounts may provide a bit more flexibility, but the overall benefits of a 401(k) vastly outweigh the advantages of those options. Generally speaking, an ideal investment would have all of the following qualities:

1. Low Risk
2. High Return
3. Consistent Returns
4. Favorable Tax Treatment
5. Minimal Barriers To Entry
6. Minimal Manual Management Required

With the right investment strategy, a 401(k) fulfills just about all of these requirements. Sounds like the perfect investment to me! Don’t believe it? Lets step through each item.

The vast majority of employers with 401(k) plans offer some amount of dollar matching. Whether it’s dollar for dollar (i.e. 100% match), 50%, 25%, or 10%, for our purposes, doesn’t matter. What's important is that it’s free money. It’s an instant and guaranteed return. As soon as your contribution is deposited into your account you automatically receive the matching funds from your employer. The most common matching schedule would give you an immediate 50% return on your contributions, up to a certain percentage of income (a maximum of 6% of salary is common). As far as investments go, I feel very comfortable saying 50% is a high return. In fact, 10% would be high return! Remember this all happens before any investment gains. The actual growth of your investment is just extra icing on the cake.

Guaranteed, instant returns are about as consistent as you can get. As we’ve already noted, that’s exactly what employer matching gives you. If you contribute, you get paid. It’s that simple.

Traditionally, 401(k) contributions are made on a pretax basis and all earnings accrued are tax deferred. This means, you owe no taxes on anything in your 401(k) until you withdraw the funds. So, every dollar you contribute to a 401(k) lowers your taxable income for the year. This is perhaps, the greatest benefit of a 401(k) investment account. Lowering your taxable income decrease the taxes you owe, resulting in more money in your pocket, instead of the government’s.

The main barrier to investing in a 401(k) is that your employer must choose to offer the plan before you can gain access. This may seem like a tough obstacle to navigate but, according to a recent estimate by the US Census Bureau, 79% of all U.S. employees have access to a 401(k) plan or some equivalent (though, regrettably, only 32% actually participate). So, whether you know it or not, it is very likely that your employer offers a 401(k) plan which you can enroll in. As long as it is offered, all you need to do is sign up. The enrollment process is usually straightforward and requires minimal effort on the part of the employee. If you fall into the 21% of employees who don’t have the option of a 401(k) at work, check out these other great investment accounts you can take advantage of to help grow your wealth.

All you need to do to set up your 401(k) account is choose a contribution rate and select your investment options. Once you’ve done this, in theory, you never have to look at the account again (I highly recommend you review it at least once per quarter). 401(k) contributions will then start being made automatically, via payroll deductions. The money never touches your normal bank account. All of the investing happens automatically, based on your investment elections. You can sit back and just let it grow. When it’s time to retire, your funds will be waiting for you in the account, fully grown into a retirement nest egg.

The psychological impact of this process should not be overlooked. Since everything happens automatically and behind the scenes, you’ll never be tempted to spend the money. It will be as if you don’t have it, and so you’ll learn to live on less while actually saving more. It’s automated saving and investing made easy!

Ability to take out a loan – You can take out a loan against your 401(k) (though I recommend you only do this in an emergency situation). When you pay back the loan, all payments and interest go to you.

Protection from creditors – 401(k)s are protected from creditors and tax liens.

Lifetime contributions – Unlike some retirement accounts, you can continue to contribute to a 401(k), at any age, as long as you are working.

Assumptions
Salary = $50,000
Invested Amount = $18,500
Tax Bracket = 25%
Taxable Account Return = 20%
401(k) Account Return = 10%
Employer 401(k) Match = $3,000 (50% of contribution, up to 6% of salary)

Taxable Account Investment (with short-term capital gain)
Investment Gains = $18,500 x 0.20 = $3,700
Total Taxable Income = $50,000 + $3,700 = $53,700
Yearly Taxes = $53,700 x 0.25 = $13,425
Carmen’s Total Net Income = $50,000 + $3,700 - $13,425 = $40,275

Taxable Account Investment (buy and hold)
Investment Gains = $18,500 x 0.20 = $3,700
Total Taxable Income = $50,000
Yearly Taxes = $50,000 x 0.25 = $12,500
Carmen’s Total Net Income = $50,000 + $3,700 - $12,500 = $41,200

401(k) Account Investment (without company match)
Investment Gains = $18,500 x 0.10 = $1,850
Total Taxable Income = $50,000 - $18,500 = $31,500
Yearly Taxes = $31,500 x 0.25 = $7,875
Carmen’s Total Net Income = $50,000 + $1,850 - $7,875 = $43,975

401(k) Account Investment (with company match)
Investment Gains = ($18,500 + $3,000) x 0.10 = $2,150
Total Taxable Income = $50,000 - $18,500 = $31,500
Yearly Taxes = $31,500 x 0.25 = $7,875
Carmen’s Total Net Income = $50,000 + $3,000 + $2,150 - $7,875 = $47,275

After running through multiple scenarios, Carmen comes to the conclusion that she should definitely invest the money in her 401(k). 

Are these results surprising to you? Even if Carmen could double her return, by utilizing a taxable account instead of her 401(k), she’d still end up behind. Even without an employer match! Once the employer match is introduced, the net return of the taxable account is totally obliterated. This is the power of, what I believe to be, the worlds best investment, the 401(k).

What if Carmen had reinvested the tax savings she claimed as a result of contributing to her 401(k)?  Let's work it out.

401(k) Account Investment (with company match) + Reinvested Tax Savings
Investment Gains = ($18,500 + $3,000) x 0.10 = $2,150
Total Taxable Income = $50,000 - $18,500 = $31,500
Yearly Taxes = $31,500 x 0.25 = $7,875
Tax Savings vs Taxable Account = $13,425 - $7,875 = $5,550
Investment Gains On Invested Tax Savings = $5,550 x 0.20 = $1,110
Carmen’s Total Net Income = $50,000 + $3,000 + $2,150 +$1,110 - $7,875 = $48,385

Wowser!  The benefits just keep piling on.