-How does compound interest affect my investments over time? -Which 401(k) plan choice is right for me?
This week’s financial topic is, why should you contribute to a 401(k).
This is my favorite topic, as you know; and though we’ve briefly touched upon it on other podcasts, however; we’ve never dedicated a full episode to this.
Here’s what I say when someone asks the question, should I contribute to a 401(k), and how much should I be contributing?
Well, of course my answer is always yes, but when asked why I feel it’s so important, I say, think about this: “the good news is, we’re all living longer,” but the not so good news is that “we’re living longer.”
Meaning, if you don’t save enough to support yourself in your retirement years, you may just outlive your money. That my friends, is a very harrowing thought.
So, when thinking about how contributing to a 401(k) plan might impact your life at the age of which you hope to retire, first think about these truly critical questions that you should be asking yourself?
What will I do to stay busy?
How much money will I need to spend a month to live in my home or dwelling?
What do I want to do when I am retired?
Do I want to travel, have a fun knock-around car or vacation home?
Who would support me if I don’t have enough money?
You have to determine your needs, and your wants. This is the basic necessity vs. your discretionary “wants” over time.
Here’s what I say… if you have the ability to contribute to a 401(k) plan, you should do it, because at the end of the day, this allows you to save more than regular IRA/Roth contributions, and the harsh reality is, if you don’t do save properly for retirement, keeping all of those questions in mind, there will likely be no go fund me account set up for you; your kids or grandkids may not want to fund your retirement and your chance of winning the lottery is probably slim. So what will you do?
With all this being said, let’s break down what is a 401(k) retirement plan, and talk about the two types of contributions you can make as long as your employer allows for both.
The 401(k) Basics
A 401(k) plan is a tax-advantaged, defined-contribution retirement account offered by many employers to their employees. Employers may also make matching contributions.
There are two basic types of 401(k)s. The traditional and the Roth which differ primarily in how they're taxed.
There are two key differences: In a traditional 401(k), your contributions reduce your income taxes for the year they are made, but your withdrawals are taxed at the time of distributions later in retirement, or if you start taking early withdrawals at 59½, or any hardship withdrawal.
With a Roth, you make contributions with your post-tax income but can make withdrawals tax-free when it’s time to take distributions in retirement.
Since a Roth 401(k) is funded with after-tax dollars up to the plan's contribution limit, this type of contribution account is well-suited if you think you will be in a higher tax bracket in retirement than you are now, as withdrawals are tax-free when you will be taking distributions in retirement.
The earliest that money can be taken-out in any of these accounts without penalty is 59 and 1/2 years of age regardless of which you choose for a qualified distribution.
The Difference with 401(k) and the Paycheck
So Let’s run through a few examples of how these accounts affect one’s paycheck. Let’s call this person . . . Brandon K
Suppose Brandon makes a $4,000 monthly salary per week and he is taxed in total from the government at 30% and he wants to deposit $200 into his Roth 401(k).
At $4,000 Brandon’s tax from the government is $1,200 so his monthly income is $2,800. Next he deposits $200 into his Roth 401k with his after tax money, which leaves him with $2,600 of disposable income.
On the inverse, the traditional 401(k) contribution of $200 is taken from the $4,000 before tax leaving him with $3,800 and then he is taxed at 30%. Hence, $3,800 multiplied by 30% is $1,140 and leaves him with $2,660 at the end of the month for his disposable income.
Now the difference here is only $60; however, we always talk about the time horizon in letting your investments grow and while doing this, you’ll have more money in your pocket and paying less income tax.
Required Minimum Distributions
The traditional 401(k) pre-tax contribution will force your mandatory distributions at 72 years old, based on a life expectancy table.
Now for the Roth 401(k) you may be also subject to a required minimum distribution at age 72; however, you can roll that money over to a standard Roth IRA prior to avoiding that required minimum distribution.
To sum this up you can roll over your money from a 401(k) into a traditional rollover IRA and the Roth 401(k) can be rolled over into a standard Roth IRA just prior to 72 years of age. .
Compound Interest Comparison
Let’s look at the examples of how saving early can impact your contributions with compounding interest; and who loves compound interest? We do!
Let’s go back to Brandon, and say, he started his contributions at age 25, but stopped contributing at age 35.
Now let’s say Brandon contributed just $100 a month, for 10 years, which is $12,000.
Now let's say Brandon’s wife Lucy, started her retirement plan contributions at age 35, and contributed until she was 65, saving the same $100 per month, for 30 years, saving a straight 36,000.00.
Now, let’s say, they both were invested in a target date aged based value fund, at an average of 7%. With this illustration, we see that Lucy saved three times as much, for three times as long, but at age 65, Brandon would have $135,044, and Lucy would have $121,288.00.
Why? Because Brandon started 10 years earlier, and allowed compound interest to do its work for 10 years longer. This is why we say, compound interest is our best friend!
The interesting thing is that Brandon still has more than $12,000 than Lucy and his total investment was $12,000 even 40 years later.
Which 401(k) is Better?
As a general rule, if you expect to be in a lower tax bracket after you retire, you may want to opt for contributing to a traditional 401(k) and take advantage of the immediate tax break. Secondly, if you have higher income now, the deductible contribution makes sense as you will be reducing your full working income in retirement and likely won’t have major taxable income streams.
On the other hand, if you expect to be in a higher bracket in retirement, you might opt for the Roth so that you can avoid taxes later when you retire. This may apply if you will have a large overall taxable savings for retirement, meaning, you may have investments in accounts outside of your tax deferred accounts, or income from dividends and interest, or large potential capital gains over time that you may incur, or maybe even a large business liquidity event.
In addition, a Roth might be the right choice for a younger worker whose salary is relatively low now but likely to rise substantially over time meaning you really don’t need that tax break now and still fall within the income limits for the Roth contribution.
Since no one can forecast what tax rates will be decades from now, neither type of 401(k) is a sure thing for tax planning, and if you are younger, consider that you may not know your overall situation in the future. For this reason many advisors suggest that you hedge your bets, and have a complimentary allocation between the two; putting some of their money into each.
A good side note is to speak to your tax professional as he/she can tell you what is the best option for you from a tax perspective. As you get older and hopefully increase your earnings, typically people lean toward the traditional 401(k).
How Much Do I Invest?
The rule of thumb for any retirement savings is putting away a minimum of 10% up to 15% of your income now.
Keep in mind that it is never too late to start saving, but starting a savings plan the minute you get into the real working world is the most critical piece. If your employer matches anywhere from 3-5%, remember to count that into your overall goal of 10%.
If you can do more, great! Try to increase each year by either committing to 1% annually, or even when you get a raise or a bonus. We know, this has been said many times, but you can find money if you want to and even 10.00 is better than no dollars!
Scale back on dining out or coffee or create a meal plan to cut down on grocery costs and food delivery services such as DoorDash or UberEats.
For example we talked in Podcast #33, How Long-Term Sustainable Products Can Reduce Your Budget While Helping the Environment and that we have saved $1,000 a month that we invested in the market.
Compound Interest Growth
Let’s throw out a few numbers about contributions and compound interest:
The max contribution for the 401(k) and the Roth 401(k) is $19,500 and if you are 50 or older you can also add up to $6,500 in contributions.
All right. How about some stats on compound interest?
If you invest $100 per month for 30 years at 7% interest will accumulate $121,288. If you invest for 40 years you’d have $256,331.
Now imagine investing $300 per month for 30 years at 7% interest; you’ll have over $363,862 and for 40 years over $768,994.
Now let’s do $500 for 30 years; that’s $606,438 and 40 years; $1,281,657.
On the whole it really doesn’t take that much. If you can get to $500 the numbers are clear. If you are disciplined the math will do the rest for you.
So now it's time to recap:
A 401k is a tax-advantaged, defined-contribution retirement account offered by many employers to their employees. This is not a required benefit offered similar to health insurance in that regard.
Why is it so important to save for retirement and contribute to your 401(k) if your employer offers one? You need to ask yourself these questions:
Where will I live? What will I do to stay busy? How much money will I need to spend a month to live? What do I want to do when I am retired? Do I want to travel, have a fun knock-around car or vacation home? Who would support me if I don’t have enough money?
Share your plan with others - get excited about making goals, and even travel plans with friends or family for your retirement years, and creating a lifestyle to keep up with those that have a good plan.
Understand that whatever you make now, you will need 80% of that replacement income in retirement. Social security should not be a given, and should only be counted for about 40% of income replacement. For example, if you make $50,000 per year, you’ll need $40,000 in retirement.
Remember, the general rule is, If you want to retire by age 65, you should be setting aside 10-15% of your income. Try to start saving as early as age 25. If you wait until 35 to start, you have to save 15 to 20% of your income to retire by 65.
The most important item is that you won’t achieve any of this unless you budget by paying yourself first! So make a plan and treat your 401(k) plans like a house or a car payment and keep increasing your contributions over time. In time, the money does add up!
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