As featured in The Wall Street Journal, Money Magazine, and more!
     

Best Feature of a 401(k) Plan: Employer Contribution

This article was written by in Investing. 8 comments.


A Reddit user recently posed this question to her fellow community members:

Right now my fiancé and I have 2 student loans, 2 vehicle loans, small credit card debt, and a mortgage. We want to start the snowball debt payment method and want to apply a little more income to accelerate the process. My company contributes 10% to my 401k regardless of what I contribute. Is it wise to take the 5% I would normally contribute and apply it to our debt payoff?

401(k) plans vary in quality, as do the policies of the companies that offer these plans to their employees. The fact that this employer contributes 10% of an employee’s salary to the 401(k) plan automatically is amazing, but rare. In another thread on Reddit, the same user recently mentioned she is 26 years old, earning $58,000 a year. The $5,800 she automatically receives in her 401(k) is a benefit that could make any saver jealous.

Through the recession, many employers stopped contributing to their employees’ 401(k) plans, and most employers’ contributions are activated in a way that matches some level of the employee’s own contributions. That is, if the employee chooses to receive all of their income in their paycheck rather than contributing to the 401(k), the employer contributes nothing. Some companies that eliminated their matching contributions are starting to bring them back, but often at a reduced level.

It’s hard for financial planners to provide accurate advice when their audience covers a wide variety of situations, but the general opinion seems to be that 401(k) plans are good as long as there is an employer contribution included. Take this away, and you generally have a high-cost investment vehicle that only allows certain investment choices, like expensive, actively-managed mutual funds or annuities. The tax-advantaged nature of 401(k) accounts can be positive, too, but someone early in their career might be better off paying tax now, while their income is relatively low and while income tax rates are historically low.

Economists tend to think that income tax rates can’t stay this low for long, so the known amount of tax you’d pay now will likely be less than the unknown amount of tax you’d pay when you retire. Future tax estimations are at best guesses. Economic life forty years from now could present situations barely imagined today.

Consider it takes no effort on this Reddit user’s part to receive the full benefit of the employer’s contribution to the 401(k), I suggest not investing in the 401(k) until all other investing and debt payoff options have been exhausted. That includes starting a Roth IRA, building an emergency fund, and paying off debt. The priorities of each change depending on how much you have available. 5 percent of $58,000 is $2,900, or about $240 a month.

Assuming this Reddit user is already paying off debt, I would just split this amount in three. Add $80 a month to debt payoff, $80 a month to establishing the root of an emergency fund, and $80 a month to a Roth IRA. From there, shift priorities in favor of debt payoff if any of the interest rates on the debt is higher than 4 percent or so: perhaps choose $120 towards debt, $60 towards savings, and $60 towards the Roth IRA. The user should also shift priorities in favor of the emergency fund if she believes her income stream — the job — is even a little at risk and if there isn’t any other savings to help pay for expenses if income disappears.

When it comes to paying off debt, I suggest the Debt Avalanche rather than the Debt Snowball, but unless there is a large amount of debt or the interest rates vary wildly, there isn’t that much of a difference between the two methods. With the Debt Avalanche, at least you have the satisfaction of knowing you aren’t spending one cent more to pay off debt than you need to.

She has flexibility with that 5 percent of her salary because her amazingly generous employer contributes to her 401(k) regardless of whether she contributes herself. That’s a rare situation, and I suggest taking advantage of it completely. The employer’s contribution is the best feature of any 401(k) plan, and there is a more difficult question for those employees who do not have this benefit in any form: whether to contribute to the 401(k) at all.

TL;DR: “Yes.”

I am not a financial adviser or planner. These opinions are based on my own observations. If you are concerned about your financial situation or have questions about choices that affect your finances, you should seek help from a professional.

Reddit

Published or updated June 19, 2012. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

Email Email Print Print
avatar
Points: ♦127,365
Rank: Platinum
About the author

Luke Landes, also known as Flexo, is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about him and follow Luke Landes on Twitter. View all articles by .

{ 8 comments… read them below or add one }

avatar krantcents

I think the reader should find other ways to reduce her debt rather than stopping her 401K contribution. Even if her employer did not contribute, there are tax consequences and she gives up the advantage of contributing early. Time is very important for a 401K.

Reply to this comment

avatar Juggler314

Good god, my employer gives us 3% regardless and most people consider that amazing – 10% is shocking – it must be a small company.

@Krantcents that attitude is fine if your entire retirement plan is based on a 401(k) – which is probably a bad idea, paying down debt, a roth IRA and other things are all valid retirement planning as well. Just like you shouldn’t own just one stock, your entire retirement plan shouldn’t be wrapped up in a 401(k) – what if interest rates trend upwards for the next 30 years – you will really be wishing you had done something different than just maxing out your 401(k).

Reply to this comment

avatar Evan

I feel like that can’t be right. I have never heard of 10% no matter contribution! That being said sounds like really good advice.

Reply to this comment

avatar jim

Great benefits like that are rare but it happens.

Here’s a list of some of the best 401k plans :
http://bucks.blogs.nytimes.com/2011/12/20/brightscopes-top-rated-401k-plans-for-2011/
United pilots apparently get 16% for free.

I used to get 12% for free at my job, but they’ve since cut it down to 6%.

Reply to this comment

avatar Juggler314

And actually 3% probably isn’t as rare as I made out – as that’s the minimum to qualify for a safe-harbor plan. So a lot of tiny companies probably do this (otherwise the owner/other highly paid individuals wouldn’t really be able to contribute much). http://www.julyservices.com/401ksafeharbor.aspx

Reply to this comment

avatar Mike Collins

A non-elective contribution of 10% seems excessively generous in today’s economy, but if that’s what she is getting more power to her. That goes a long way toward her retirement savings, so if I were her I’d concentrate on paying down debt and contributing to a Roth IRA.

Reply to this comment

avatar Lance@MoneyLife&More

If the employer truly contributes without an employee having to I say take advantage. I had an employer that gave 3% and didn’t require an employee contribution. I would be starting an emergency fund and paying off any high interest rate debt first if I were the person asking the question. Once the high interest rate debt is paid off I’d start splitting the debt repayment money with a Roth IRA as well. I’d categorize high interest rate debt at 9-10%+

Reply to this comment

avatar qixx ♦1,813 (Half-Dollar)

One of my past employers would contribute 4% as long as we were contributing something. Even if that something was the plan minimum of $1 per paycheck. Like others have said – good advice.

Reply to this comment

Leave a Comment

Connect with Facebook

Note: Use your name or a unique handle, not the name of a website or business. No deep links or business URLs are allowed. Spam, including promotional linking to a company website, will be deleted. By submitting your comment you are agreeing to these terms and conditions.

Notify me of followup comments via e-mail. You can also subscribe without commenting.

Previous post:

Next post: