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401(k) Contribution Matches Not Really “Free Money”

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401(k)s are making everyone poorer. That’s the conclusion from a study by the Urban Institute in which they analyzed qualified defined contribution plans, the official category of 401(k) plans, and concluded that employers reduce worker salaries when those workers are eligible for 401(k) plans with matching contributions.

Toder and Smith looked at a Census database on pay and pension plans, and how much employers contribute. They looked at workers who had 401(k) plans in which their employers contributed to retirement savings automatically or by matching employee contributions and compared them with workers who had either a 401(k) with no employer contribution or no 401(k) at all. All else being equal, they found that workers at companies that contributed to their employees’ 401(k) accounts tended to have lower salaries than those at companies that gave no retirement contribution. In fact, for many employees, the salary dip was roughly equal to the size of their employer’s potential contribution.

In other words, if your employer said they’d match your contributions up to 3%, they were probably offering you a salary that was 3% lower than what they would be offering if there were no 401(k) available to you. The actual figures are less dour but that’s the gist.

This isn’t that much different than cash back credit cards (work with me, it’ll make sense shortly). When I make purchases with a cash back credit card to buy a box of cereal, I get a very small percentage of that back to me as the cash back reward. If I were to make the same purchase with cash, I get nothing back. The box of cereal costs the same to me regardless of my method payment, so paying with cash subsidizes those who are paying with a credit card. I’m paying a higher price because the seller knows some people will pay with a credit card and that credit card charges a fee. Since he doesn’t know how someone will pay ahead of time, he simply assumes everyone uses a credit card and raises prices. If someone doesn’t, he wins. If they do, well he’s covered.

It’s the same with the 401(k). A company knows how much it can afford to pay a new employee. It deducts all the fixed costs, such as how office space and a computer, along with benefits, like medical insurance and the 401(k), and arrives at the salary figure. The 401(k) contribution looks like “free money” to the employee, because it is, but it really comes out of their total compensation. Since the 401(k) is optional, unlike a pension, the company “wins” in the case when an employee doesn’t contribute and get the matching funds. If they do, well it’s all been taken into account when setting salaries.

The takeaway from this is clear – if you can, you have to contribute to a 401(k) if your employer is offering matching funds. Your employer is assuming you will and they’re paying you less because of it. What this also means for workers who don’t have access to a 401(k) or don’t get matching funds, don’t be too upset because it just means your employer is paying you more.

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17 Responses to “401(k) Contribution Matches Not Really “Free Money””

  1. David M says:

    “The takeaway from this is clear – if you can, you have to contribute to a 401(k) if your employer is offering matching funds. Your employer is assuming you will and they’re paying you less because of it. What this also means for workers who don’t have access to a 401(k) or don’t get matching funds, don’t be too upset because it just means your employer is paying you more.”

    I will agree with point #1 – if their is a match you need to take advantage of it.

    However, point #2, may or may not be valid. Small companies – those that often do not have 401Ks- often pay less money than larger companies because they just do not have the money to pay higher salaries.

    Regarding, “401(k)s are making everyone poorer.” Well the article did NOT really say that, it said that was true for low income people but for higher income males and higher income females their was not much decrease in total componsation. I would think most readers of your blog are in the higher income group or at least save like a higher income person. Thus for most readers of your blog are NOT being made poorer by their 401ks.

    Just my thoughts and opinions – love your blog – it gets me thinking!

    David

  2. Kathryn C says:

    VERY interesting. I hadn’t thought about it that way.

  3. Kurt says:

    I’m not surprised (or alarmed) by this conclusion. Employers rightly see benefits–including 401(k) matches–as part of employees’ compensation packages, the big part of which is pay. Still, if I had a choice between 3% more salary or 3% 401(k) match, I’d choose the match because of the tax benefits. Am I missing something?

  4. Jason says:

    I think folks have put waaaaay too much stock in the power of employers setting pay rates. Simple fact of economics is supply and demand. If employeers have a demand for a certain skill set, and the supply of that skill is low, they will have to pay a higher rate. We as workers are the supply. If we refuse to do the work they demand at a rate, our supply decreases. We as employees set the rate. If someone is willing to do the same job for less money that increases supply and effectivly lowers your chance of getting a higher salary. I guess what im leading to is the fact that total compensation, ie salary+401k+pension+daycare+health care+company car+free coffee in the break room+ whatever…IS CONTROLLED by supply and demand. No one man or woman dictates what you get paid. You in the end are the one that accepts that compensation package or not.

    • cubiclegeoff says:

      The supply and demand argument is a bit simplistic in this case. This would really only be true if everyone really knew what others were getting paid for the same job and same work. Since it’s hard to really figure that out, employers have the advantage, not the potential employee.This argument also doesn’t work since emotions often take over and people will do things for less than they’re worth for a variety of reasons.

      • Jason says:

        I have to disagree, cordially of course. This leads to why we are seeing the 99% problems today. Average salaries by position are common knowledge. In fact, more and more detailed surveys are being released all the time spelling out exact wages by category. Wages are determined by supply. Whats been skewing the numbers for decades is the simple fact that we have been over enrolling folks in college for degrees in things that arent in demand. Simple fact, science and engineering graduates have remained flat, while others have increased enrollment. Demand for engineering in the US has increased, and so have wages. Now, globalization is also an issue, because now, an employeer can recruit globally. So include china and india in the mix, and wages arent as high because the supply is normalized. Just because something is simple doesnt mean it isnt the right answer. To say that folks cant determine what their wage is for a position is simply false. I do agree, given circumstances people will work for a lot less, but how many? 1, 2, 1000? Your back to the supply and demand arguement.

  5. Don D says:

    Generally contrabutions to 401K are tax free,where 3% wage would be taxed.

    • David M says:

      Tax free until the money is taken out of the 401k and then every dollar – the dollars you put in and dollars earned are taxed as ordinary income. That is, there is no captial gains rate for money coming out of a 401K.

      Do I fund my 401K to the max – you bet you. However, the risk is that I and others will end up paying more taxes later than what was saved now.

      • Courtney says:

        Not exactly every dollar. You’d get to get some of those back tax free each year through the standard deduction and exemption(s).

  6. Quinn says:

    Maybe I’m just dim, but your credit card versus cash scenario doesn’t make any sense to me.

    How are the seller raising prices and the credit card company charging a fee connected? And what source did this information come from? Also, many cards don’t charge any fees. I have no fee on mine, and I always pay the balance on time so I don’t pay extra for interest. So for me, that small amount of cash back IS free money. Whether or not the seller is raising prices for everyone because we use credit cards is out of my control, so I might as well use the credit card instead of cash so I get the small amount of cash back.

    • Texas Wahoo says:

      That’s exactly what this article is saying. Cash back credit cards are free money compared to using cash. But in the absense of cash back credit cards, the product would be cheaper in the first place, so the cash back is not really free money.

      • David M says:

        But, since they will not give you the money for not using a credit card, it makes sense to use a credit card and find one that gives you the most points back (also the most sign-up points.).

        • Texas Wahoo says:

          Which is one of the points of the article. If your company offers a match, you should take it, because they won’t give you more money for not taking it.

  7. Ladam8518 says:

    When I swipe my credit card (or debit card) at a merchants place of business, the merchant ends up paying a fee to Mastercard, Visa, or whichever network my card belongs to. This fee has recently been capped by financial regulation for Debit Cards (and was the motivation by Bank of Americas proposed Debit Card fee on their customers).

    This is the fee that the merchant has priced into every piece of stock he sells regardless of whether or not I pay with credit. I believe this is the fee that Jim is talking about in the post.

    • David M says:

      However, if the merchant is really doing this perfectly as Jim and you are assuming – and only 1/2 of people use credit cards and 1/2 use cash. The discount assuming credit cards are not accepted would only be 1/2 of fee charged by the credit card company. Thus, go ahead and use your credit card and you are being subsidized by the people that pay cash.

  8. Joshua Tokle says:

    “In other words, if your employer said they’d match your contributions up to 3%, they were probably offering you a salary that was 3% lower than what they would be offering if there were no 401(k) available to you. The actual figures are less dour but that’s the gist.”

    Hi Jim. I want to pick on this statement because Todor and Smith’s research looked into precisely this question (that is, they started from the conventional wisdom that 401(k) contributions and salaries roughly offset one another, and showed that this isn’t the case). As you probably read, they found that for those in the bottom 40% of income, a dollar more in employer contribution translates to only a 29 cent* reduction in base salary. At a $35K salary (the 40th percentile), that means that a 3% contribution translates to only a 0.86% drop in salary. In dollars, that’s $1,050 in your 401(k) versus $304 in your pocket.

    Anyway, instead of calling it free money, we should say that by not maxing out your employer contribution you’re taking a voluntary pay cut.

    * 29 cents for men, 11 cents for women.

  9. Anonymous says:

    I always had a suspicion this was how it worked. IT feels sort of bittersweet to see it backed up.


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