We all want the highest rate of return possible. This has been ingrained in us since the first day we started learning about money. But getting a little better understanding of how your rate of return works inside your qualified plan may help you see some truths about qualified plans you didn’t realize.
What do I mean? The answer is simple, so let’s take a look inside a 401k, or any corporate matching qualified plan, and see how our rate of return is affected.
Now the first thing we need to understand is that a 401k is going to defer the tax, meaning put the taxes off for later.
If you went to the bank and asked them for 10 year loan, you would ask them for the terms of the loan as well. What if the banker said this to you, “you know what, I really don’t know how much I’m going to need, so how about this. Take the money now, and in 10 years, I’ll let you know how much I need.”
You wouldn’t take that that loan in 1000 years. But isn’t that the same thing the government is offering us in our qualified plan?
That being said there is 1 thing to first remember about our qualified plan, that is taxes.
If I get an overall 10 percent rate of return, how do taxes affect this?
Well if I’m in a 35 percent tax bracket when I retire, but for the first 20 years I was in a 21 percent tax bracket, does that affect my rate of return?
Yes. You have to remember if you pay a fee that you originally wouldn’t have paid, you have given up dollars that you didn’t have to give up. So, this 20 years at a 21 percent tax bracket is going to lower our rate of return to around 9 percent.
Even though this is out of your control, it’s important to understand.
Now here is the real meat of what I wanted to share with you. Every dollar you contribute over your qualified plan match lowers your rate of return.
Does that sound confusing? Untrue? Well let’s take a look at a scenario and figure this out.
So let’s say Joe is calculating his qualified plan rate of return. His investment return is 10 percent (I’m going to use 10 percent throughout this entire post, please understand this is purely to teach the philosopy behind the concepts here and not an actual account). He contributes $5,000, the minimum he has to contribute to get a $2,500 dollar match. His rate of return is 12%. Why? Because his match is increasing his rate of return.
However, let’s say he wants to increase the amount of money he puts into his qualified plan, let’s look at the dollar amount and its corrisponding rate of return.
$7,500 – 11.44 rr
$10,00 – 11.12 rr
$15,000 – 10.77 rr
$20,000 – 10.5 rr
What does this mean? It means that the more money I put in on top of my match, the lower my rate of return is going to be, because I have lowered the effectiveness of my company match. The higher my company match is as a percentage of my dollars, the higher my rate of return will be.
Now there is one other thing to understand, and that’s the difference between a qualified plan and a tax free account.
If I am getting a 10 percent rate of return in my qualified plan, and a 10 percent rate of return in a tax free account — let’s say no match in either to start out — which balance will be higher in the end?
The answer is, they will be the exact same.
This is because what is happening in a qualified plan? The taxes are a portion of the dollars, and that portion is growing right along side with your principle. So all that is happening is your taxes grow at the same rate as your actual dollars.
So the only difference in a qualified plan vs. a tax free account is the match.
If I contribute $5,000 dollars to a tax free account, and $5,000 dollars to a qualified plan with a $2,500 dollar match, in the end I will have around $300,000 dollars more in my qualified plan. However, what if I raise my contributions to $20,000 a year?
My qualified plan beats my tax free plan by $300,000 dollars. No change. The match is all that has an affect here.
So, in order to get the highest rate of return in your qualified plan, what do you need to do? I hope you can answer that question now, and I hope you see now that the real value in a qualified plan is the match, contributing the minimum amount to get the match is going to give you the highest rate of return. And that there still is the potential risk of losing money depending on what the government decides to do with taxes.