The rate of return of your contribution is enhanced by the company match. In some cases the company match may be sufficient to cover all the taxes due. The only thing going on with unmatched dollars is tax deferral. |
The match is a valuable incentive to contribute dollars to the qualified plan. Contributions above the match are receiving tax deferral only. Perhaps there are other alternatives which have more benefits as well as tax deferral with the same investment opportunities. Due to the fact that the qualified plan has deferred the tax calculation perhaps we should consider diversifying the amount of our funds. |
The math for this proof is solved with three spreadsheets. The three spreadsheets are: 1.Calculate the rate of return for all contributions. 2.Calculate the rate of return for the matched contributions. 3.Calculate the rate of return for the unmatched contributions. Each spreadsheet calculates the cash flow for each year (row). The cash flow for years of growth is the contribution made less any tax shield. The tax shield is the amount of taxes deferred by making the contribution. It is an apparent tax savings. Whether it is a true tax savings or not depends on the tax bracket at the time of withdrawal compared to the current tax bracket. The calculation or estimation of the current balance in column two of the first row may not be obvious. The QP spreadsheet current balance uses the input Current Balance as its current balance. This is straightforward. However, the Taxable Investment spreadsheet prorates the input Current Balance by multiplying the input Current Balance by (Annual Contribution / (Annual Contribution + Company Match)). The assumption is that with the taxable investment, there would have been no company match, so the current balance is smaller for the taxable investment. For example, it the employee is contributing $2,000 and the company is matching with $1,000, the current balance for the taxable investment will be only 2/3 or (2,000/(2,000+1,000)) of the QP current balance. The cash flows are presented in the last column. They are negative during the years of investment. The negative means a cash outlay or investment. A positive cash flow is shown in the last column of the last row. This cash flow assumes the investment has ended and the taxes due at withdrawal have been paid. It is under the last row with a year number because it occurs at the end of the last year, compared to all the other cash flows occurring at the beginning of the year. The cash flows are determined from the employee's perspective. That is, the company match is considered a zero cash outflow. It is like a gift or immediate return on investment. A different perspective would be to consider the return to the employee and employer (a group of two investors). This would change the treatment of the company match. It is NOT the perspective we chose to use. The internal rate of return function is used to calculate the rate of return. You can verify the rate of return by entering the cash flows into a financial calculator or spreadsheet. Then using the internal rate of return function to calculate an IRR. Determining the Potential Income Once the final balance is calculated, you may click the [Income Calculator] button to calculate the potential income from the balance. The potential income is presented from four different calculation methods. 1.The income is calculated taking the interest only at the beginning of the year. 2.The income is calculated taking the interest only at the end of the year. 3.The income is calculated taking a withdrawal of interest and principal for a number of years at the beginning of each year. The number of years may be changed. 4.The income is calculated taking a withdrawal of interest and principal for a number of years at the end of each year. The number of years may be changed. All four of these are Time Value of Money calculations. They may be verified by using a financial calculator or a spreadsheet with a TVM function. |