A reader recently sent in a question on how much it really costs you to contribute to your 401(k). I’ve always advocated that you contribute to your 401(k), regardless of whether your employer offers a match, and I will continue to advocate doing so until something drastically changes in retirement planning. Now, the reader was actually in a discussion with someone else about how your contribution to your 401(k) was cheaper than it’s actual dollar cost to you, at least initially, because of the fact that it’s pre-tax. So, let’s cover the basics and give our friend some ammunition to go back to the debate stand.
First off, it’s cheaper initially because you don’t pay tax on the funds yet. So, if you’re in the 25% tax bracket, when you contribute $100 it’s really only $75 out of pocket for you. On that basis alone, I think most would accept the argument that your 401(k) contribution isn’t as expensive as one may expect looking at nominal dollar amounts. However, let’s look at it from a different perspective, from the cost of the tax being paid (either today on non-contributions or tomorrow on appreciated 401(k) assets).
However, let’s actually compare the cost today ($25) versus the cost of the taxation in the future, given a few assumptions. First, let’s assume your money earns a reasonable 8% and inflation is a healthy 4%. Let’s also assume that your tax rate remains 25%, which is probably the most risky of the assumptions. Given the growth rate of 8%, your $100 in 40 years will be worth $2,172.45. If you tax that at 25%, that’s a tax of $543.11! $543.11 is much more than $25 right? Well, that’s $543.11 in 2047 dollars, which is only $113.12 in 2007 dollars. But isn’t $113.12 over four times more than $25? Yes, but that’s $113.12 you don’t pay today, you pay that in 40 years… the time value of money makes $113.12 in 40 years worth only $23.56 today (given the same 4% rate used for inflation). So you get more money and you pay less tax in the future, not bad!