The major secret to 401(k) investing success is that the money you get from an employer in matching funds, combined with the tax deduction you receive on retirement contributions, can turbo-charge your investment returns. Unfortunately, it seems as if a significant minority of 401(k) investors doesn't understand this. They complain that the system is rigged and that everyone from "the rich" to "Goldman Sachs" is out to get them. The truth is, they are their biggest enemy. They don't understand how 401(k) plans work, the structural advantage of investing through a 401(k) account, or why so many people manage to grow their net worth using 401(k) money.
The Top Reasons 401(k) Investing Can Be So Profitable
Imagine you save $5,000 in a year and your employer matches you dollar-for-dollar, or $5,000. You have instantly doubled your money. It would take a decade of you earning 7.2% compounded to achieve the same thing had you been putting money in a regular brokerage account at a stock broker.
But wait - it gets better! If you are in the 25% tax bracket, you were able to get a deduction, saving you $1,250 in taxes when you put your money into your 401(k) account that you would have had to otherwise pay to the IRS. That amount effectively serves as an interest-free loan from the Federal government because had you not saved money through your 401(k), you would have owed this on April 15th.
Adding these two figures together, you are essentially only investing $3,750 of your own money in exchange for $10,000 in money working for you inside of your 401(k) account. That means that you could experience a loss of 62.5%, or $6,250, before you saw a single penny of the money that actually came out of your pocket disappear.
A 401(k) Account Gives You the Benefits of Leverage with None of the Drawbacks
From a financial standpoint, an investor in this situation would have leveraged every $1.00 in net money invested in a 401(k) into $2.67. (For employees that receive better 401(k) matching, such as 150% or 200% on contributions, that figure is even higher.) That is money working for his or her benefit. As a 401(k) investor, you keep this money invested until you retire, at which point you pay regular income taxes on funds withdrawn from the plan.
This means you get to earn dividends, interest income, and capital gains on $2.67 even though you only invested $1.00 of your own net money. A 3% dividend yield represents an 8% yield on your actual investment.
The financially ignorant won't realize this. They see a 401(k) account with $100,000 in it, of which only $37,500 represented net cash out of their pocket, and freak out when the balance drops to $80,000. They believe they have "lost" $20,000 from the all-time high when, in fact, they are $42,500 richer than they would have been had they not invested in a 401(k) plan at all. They continue to make mistakes, sell when the market falls, buy when the market rises, and wonder why their entire financial life seems to be one series of setbacks after another. The financially savvy don't make this mistake and instead focus on maxing out their annual retirement contribution limits.