One of the benefits of a 401(k) is that there are two account options. There is the Traditional 401(k) and the Roth 401(k). An employer who offers a 401(k) may only offer the Traditional 401(k), but since the Roth 401(k) became an option in 2006, employers have begun to offer it as well. The difference between the two accounts is in when you pay ordinary income tax. Each option has its advantages and disadvantages. To save an extra $100,000 in retirement I’m going to focus on the Traditional 401(k).
What’s the difference between the two accounts?
- With a Traditional 401(k), you contribute with pre-tax money, your contributions and earnings grow tax-deferred but you pay taxes on the withdrawals at retirement.
- With the Roth 401(k), you contribute with post-tax money, and your contributions and earnings grow tax-free and you pay no taxes on the withdrawals at retirement. (Of note, however, if you employer provides a matching contribution, and you contribute to a Roth 401(k), your employer’s dollars are pre-taxed and you will pay taxes on those withdrawals is retirement.)
What’s the benefit of contributing to a Traditional 401(k)?
Let’s say you decide to contribute to a Traditional 401(k). You may ask, “Why would I contribute to a Traditional 401(k) over a Roth 401(k)?” Making the decision on which account to select depends on a range of financial considerations, and ultimately the conversation rests on what tax bracket you expect to be in when you retire. But in reality, the political climate is so uncertain it’s hard to know for sure what future tax rates will look like. Who knows, perhaps they will be sky high or incredibly low.
But one of the advantages of investing in a Traditional is you get immediate tax savings today because you contribute with pre-tax dollars. Irrespective of what you expect your future tax rate to be in retirement (i.e. over the next 30-40 years), choose the Traditional 401(k) if the tax savings today, first, incentivize you to actually start investing in your 401(k) and, second, if you want to have a higher take home pay each pay period.
How can I save an extra $100,000 by retirement?!
Let’s say you earn $47,000 on average your whole life, and you start investing in your 401(k) at age 35. At that salary, you would be in the 25% marginal tax bracket. (You can check out tax rates here.) If you contribute 6% of your salary to your 401(k), you are socking away $2,820 (=.06*$47,000) each year. Since you pay with pre-tax dollars, you get an instant 25% discount on your contributions, and you save $705 each year (=.25*$2,820). So how do you save an extra $100,000 by retirement. Save the tax savings! If you were to contribute that $705 to an Individual Retirement Account (IRA) each year until you retire at age 67, and assuming you get a 8% investment return, your amount would grow to roughly $100,000! That’s $100,000 on top of what you are saving in your 401(k)!
Here’s a 2-step simple guide to save $100,000 by retirement:
- Choose a Traditional 401(k) if tax savings today matter to you and/or incentivize you to participate in your employer’s 401(k) plan, and
- Save the tax savings each year in an Individual Retirement Account (IRA) over the long term.
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Hey Matthew,
I found the concept of saving “the tax savings” interesting. Essentially, you’re taking the hit as if you put everything in a Roth 401k with your disposable income.
As a matter of fact, you could take this one step further and do the same with your traditional IRA, and invest the rest in a taxable brokerage account!
Do you save any money beyond your tax advantaged accounts, and if so, what financial vehicle do you place them in?
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Hi Akash! You make an excellent point! By extension, you could save the tax deductions you get from the Traditional IRA and place into a taxable account. Beyond my tax-advantaged retirement accounts, I invest in a brokerage account for added investing purposes. I would only recommend investing in a brokerage account once you – or any investor for that matter – has begun to invest first for retirement through your 401(k), and then second through an IRA to supplement it. Once that is completed, you can then move on to a brokerage account for more mid-term to long-term investing purposes. Thanks for you comment and keep on reading! – Matthew
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Hey Matthew,
What about the case where someone can’t afford to max out a 401k plan. Would it still be better to put as much as you can in a 401k / ira and neglect a taxable brokerage?
The reason I ask is because although you lose out on tax efficiency, you can access the money in a brokerage without paying penalties and fees you would have to otherwise handle to take money out of a traditional IRA or 401k.
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Hi Akash! Yes, I would recommend its best to invest first through tax advantaged retirement accounts over a taxable brokerage account, at least for the purpose of investing for retirement, even if you can’t max each account out. Why? First, investing is for the long term, such as over the course of 30-40 years, and so what you have saved shouldn’t be readily accessible and therefore early withdrawals shouldn’t be taken that will incur taxes and penalties. Second, you get tax-deferred growth for a Traditional and tax-free growth for a Roth, whereas for a taxable you don’t get those advantages. Third, if you get a company match that’s free money you can’t get anywhere else and so even if you can’t max out the account then try to save at least up to the employer match. Fourth, you can elect to set up automatic salary deferrals to contribute to your 401(k), and therefore you can automate your contributions. Even if you can’t afford to max out a 401(k) I would still recommend putting money into a 401(k) and then an IRA for long term investing over a taxable account. Once you have a solid handling on long term investing, then you can advance to a taxable account for more mid term investing or simply to supplement retirement investing . – Matthew
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