I want to tell you about a guy who used to work at my current job; we’ll call him Liquid Larry.
Liquid Larry and I talked about money quite a bit. He was pretty frugal, and always preferred to keep as much of his net worth in liquid assets. Every dollar he had to his name was in cash or in a brokerage account somewhere like ETrade.
Any time we talked about personal finance, I would always ask Larry to reconsider his obsession with liquidity. He wouldn’t listen. He was convinced that liquidity is the key to financial prosperity. In fact, he was so convinced of this that he wouldn’t even contribute to our company’s 401k plan, which matches 100% of all employee contributions up to 6% of an employee’s salary.
That means he and I can put 6% of our annual salary in a 40k, and the company will add another 6%. It’s FREE MONEY!
I tried to get Liquid Larry to understand that your 401k is completely liquid if your employer matches 100%. Why? Because you can actually pull every dollar out of your 401k tomorrow, pay all the fees and penalties, and still turn a profit. Let’s look at the numbers to prove it.
Let’s pretend Liquid Larry makes $50,000 a year. That means if he contributes $3,000 (6% of his salary) in pre-tax money to his 401k, the company will add another $3,000 and he will have a total of $6,000 in the 401k account. If he doesn’t contribute $3,000 to the 401k, he will have $2,250 in liquid cash after paying taxes in the 25% tax bracket.
If He Leaves the Money in the Retirement Account
If Liquid Larry doesn’t run into a situation where he needs that money immediately, then he has $3,750 more in his 401k than he would have in his checking account. It is important to remember that Larry will have to pay taxes on the entire $6,000 (plus any interest he earns) eventually, but it’s also important to remember that he already has a 100% return on his original $3,000 investment. There’s no question investing in the 401k with matching is the best option if he doesn’t need the liquid cash.
But what if he needs the money?
If He Cashes Out Early
Maybe Liquid Larry spent last weekend out on the lake. He and some friends rented a boat, and just when the party really started to heat up, they had to return the boat to the rental shop. Bummer. Larry decides he’ll never allow such a tragedy to happen again and wants to buy a boat.
To get the money for this boat, he is going to cash out all $6,000 in his 401k. He obviously hasn’t reached the retirement age yet, so he will have to pay taxes and penalties to get to this money. Specifically, he will pay taxes on all the money at his regular 25% rate, plus an additional 10% for the early withdrawal penalty. That means he has to give the government 35% just to get his money. That’s highway robbery if you ask me.
35% of $6,000 is only $2,100. That means Liquid Larry can cash out his 401k, pay all the taxes and penalties, and still have $3,900 left over. If you remember, he only would have had $2,250 in liquid cash if he hadn’t invested in the 401k.
Investing in the 401k with matching and then pulling it out early still results in $1,650 of extra LIQUID cash. That’s a 73% return on investment.
Take the Free Money and Run
If your employer offers 401k matching, it’s simple: max it out. The one thing you’ll want to check is when the money is vested. All 401k money is immediately vested at my company, so once the match is in the account, it’s yours. Some companies require employees to leave the money in the account and stay at the company for a certain number of years before the matching contributions are vested. If your company doesn’t vest immediately, then it reduces the amount of liquidity in your retirement account.
As always, it’s probably best to talk with your HR representative to fully understand how your 401k works. Just make sure you educate yourself so you don’t pass up free money like Liquid Larry did.