Why contribute to your 401(k)?

I was surprised to learn recently that my brother, who’s otherwise financially frugal and savvy, contributed nothing to this 401(k) account, opting to rely on his own means to grow his after-tax savings. Though this is probably because his last employer made a terrible mistake when rolling over his 401(k) to an IRA that resulted in taxes and a penalty for disbursement, I still wanted to convince him that contributing to his current 401(k) in lieu of putting the amount in a savings account would be better.

The differences come from the following:

• 401(k) contributions decrease the salary upon which your income tax is calculated because they’re pre-tax
• If your employer matches any part of your 401(k) contribution, it’s free money you’re missing out on if you’re not doing it
• Your 401(k) grows tax-free while an account you contribute to with your after-tax dollars is taxed at the capital gains tax rate of at least 15%

Thanks to Moom (see below) for noting that when 401(k)s are withdrawn later in life, they are taxed at whatever effective income tax bracket you are in at that time, which can negate the first and last points above. (Though then you might be able to argue the time value of money…but since in the end it all largely depends on whether your tax bracket is higher now or in the future, it becomes a bit complicated to analyze.)

And so, voila, another excel calculator to put it all in black and white.

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