- last updated on FEB 11, 2018 -
Most people only contribute just enough to their 401(k) to get matched by their employer, but I would always max it out or at least put in as much as I can afford. Even without employer contributions, I still would max out.
Let me first discuss the power of compounding. Compounding means you get returns off previous returns. That’s what makes your money grow exponentially, so $10k invested right now will be worth exponentially more than $10k invested 20 years from now. That means the more you put away now, the exponentially less you’ll have to put away later. This applies to saving and investing with any kind of account. It doesn’t have to be a retirement account, but a retirement account can help you end up with even more money through tax advantages.
Here’s a case study of two people saving and investing through different stages of their lives, and let’s say they are using their 401(k)s for this. The maximum contribution limit for a 401(k) in 2017 is $18,000. We’ll use an annual return on investment of 8% here, but the S&P 500 has actually generated 11-12% in annualized return from 1976 through 2016. That is why I strongly advise investing in index funds! You don’t lose. 1976 was when the world’s first index fund started tracking the S&P 500, which is a pretty good representation of the total stock market. Anyway, Person A contributes $18,000 every year to his or her 401(k) from age 32 to age 60. He or she will end up with $1.85 million at the end. That’s a lot of money, right? Person B also contributes the same amount every year, but he or she is only contributing from age 22 to age 32. This person doesn’t put away a penny more, but he or she will end up with $2.4 million at age 60! Person A contributed a total of $504,000 over 28 years and ended up with less money than Person B, who only contributed a total of $180,000 over 10 years. Just let that sink in. I hope this example from a ChooseFi podcast episode illustrated how powerful compounding is. Play around with compound interest calculators online to see how your money can grow.
I’ll now get into the tax advantages of retirement accounts like 401(k). I’m referring to traditional 401(k), which is what almost everyone with a 401(k) uses anyway. The traditional part means that contributions are made pre-tax, and anything else pre-tax will have similar advantages. Pre-tax means taken out of one’s paycheck before taxes are taken from the money. Traditional IRA works a little differently, but it’s essentially still considered pre-tax. It’s contributed with post-tax income, but the amount can be deducted from taxable income. Contributing pre-tax to retirement accounts lets you avoid paying taxes on that money now, but you pay taxes later when the money is withdrawn. This means more money now to invest with and to grow until you retire.
Depending on your income level, you can even lower your current tax rate by making pre-tax contributions. For example, I’m supposed to be at the 25% tax bracket for 2017. Since I put away so much money pre-tax, I should be in the 15% tax bracket instead. That’s a 10% difference! When I finally do retire, I plan to be in a tax bracket with a tax rate no more than 15%. That means the pre-tax money I’m putting away now won’t be taxed as much in the future as it would be if I had to pay taxes on it now. Simply put, I save a lot on taxes through pre-tax contributions. Besides those with very low income in their working years, people generally don’t need as much income during retirement. Like I plan to be, most should be in a lower tax bracket than when they were working. Granted, I don’t know what the tax brackets will look like in the future when I do retire and have to pay taxes. In fact, they’ve already changed for 2018. What I know for sure is that I can get more money now to invest, so I’ll have more money in the future due to compounded returns. Any tax savings would be nice too.
It seems like most people out there recommend focusing on contributing to a Roth IRA, which is contributed with post-tax income and no tax deduction. I don’t care about IRA vs. 401(k). It could be any retirement account, but I want to discuss traditional vs. Roth. People really like the fact that the money with Roth grows tax-free, which does have some merit. It’s nice to not have to worry about taxes on that money ever, but you will end up with more money with traditional in the end through compounding. Due to the structure of tax brackets, you won’t be taxed much after retiring anyway.
A benefit of Roth IRA is allowing to withdraw the money you contribute without penalty at any time. 401(k) and traditional IRA need one to be age 59.5 to withdraw money (contributed or earned) without penalty, but there are ways around that discussed here by one of my favorite bloggers Mad Fientist. If I do a Roth ladder conversion, I still have to wait 5 years before getting money from a 401(k) or a traditional IRA. Withdrawing the principle from Roth IRA can be a form of income during that time. Keep in mind that I plan on retiring very early, so my strategy might be different than if I were to plan on retiring at 59.5 years old or older.
Mad Fientist also makes a great argument here for going traditional with IRA and discusses advantages from a FI perspective. The main point is that you can always convert your traditional IRA money (contributed or earned) into Roth IRA contribution money through the Roth ladder conversion, so you still get the benefit of money growing tax-free without having to pay taxes immediately and as much. If your income is too high though, you can’t deduct your traditional IRA contribution amount from your taxable income. At that point, you’re better off with a Roth IRA. There’s also income limits to contributing to a Roth IRA, but they’re very high. However, contributions can still be made through the backdoor Roth IRA method.
Folks, don’t think it’s too early to be thinking about retirement. Even if you don’t plan on retiring early like I do, you’re still getting a lot of tax benefits from contributing to a retirement account. Even without tax benefits, saving and investing earlier gives you more value due to compounding. If you think saving earlier in life is hard, just imagine how hard it is later with a house or kids or aging parents. Even if you are at a later stage, you should still start as soon as possible. You can always cut back on investing later, but you’ll never be able to make up lost value from investing earlier. Don’t wait until you’re eating cat food as a senior citizen.