Ryan is a recently graduated finance major whose been working for a large airlines finance department for the last 6 months. Earlier in the week, he had been informed by his HR department that the company offered a 401k package to all of its employees. As part of the plan, the company would match all contributions up to 6% of his salary. Ryan is excited about the prospect of contributing towards his retirement plan but doesn’t really understand how to best capitalize on the plan offered by his employer. What should he do? Let’s find out.
What is a 401k/403b?
401k/403b is an employer offered plan consisting of groups of stocks and bonds where you can contribute your “pre-tax” income towards your retirement. This option allows you to defer paying taxes on your contributions (“pre-tax”) until you take them out of your fund. This is extremely beneficial because it allows more of your money to compound over time. I have laid out 2 scenarios below:
In the first scenario, Ryan starts off with $10,000 at 25 years old. If Ryan contributes $1,000 per month of his pre-tax income for 40 years at a 7% return rate he will have $2,621,286.59 before taxes. If he were to take out his money from his 401k at the age of 65 with a tax rate of 28% (tax rate for individuals making less than 190k per year) he will be left with $1,887,326.35 as his final total. This is a big chunk of change for Ryan.
In the second scenario, if Ryan were to take his $10,000 initial investment, invest it in the stock market and contribute $720 of his post tax income per month (28% tax bracket) at a 7% return rate he would have $1,929,254.82 after 40 years. When he sells off his stocks, his profits will be taxed at the “long-term” capital gains rate. Capital gains tax applies to all gains from investments and not your principal investment. This percentage rate is 15% for individuals making less than $400,000 per year and 20% for those making greater than that. After all is said and done Ryan will have $1,693,206.60 left over. This is still a substantial amount of money but in the first scenario (401k/403b example), Ryan would have been better off.
Another benefit of taking advantage of your employer’s 401k/403b plan is that some employers offer to match your contributions. This means that if Ryan makes $50,000 per year and his employer matches 6% of his salary, his first 3,000 dollars in contributions will be matched. If your employer matches your contributions I STRONGLY encourage you to contribute at least the matching amount. This is FREE money given to you by your employer. If Ryan only contributed $3000 per year to cover the match, he would still have $632,859.96 in his retirement account by the time he turned 65. Half of that total would be money directly attributed to contributions made by his employer. In the next section we will explore another option that when coupled with the 401k/403b will allow you to have tax free future savings that you can use to enjoy your retirement.
The Roth IRA
A Roth IRA is a financial option that allows you to pay taxes on contributions today and not pay taxes on the gains when you decide to take your money out. This is a great option if you’re near the beginning of your career and feel that you’ll be in a higher tax bracket by the time you retire. Since you’re likely to receive raises as your progress through your career, investing in your Roth IRA is a smart investment. Another added benefit of a Roth IRA is that it allows you to access the principal you’ve invested at any time without penalty.Although I highly recommend not touching your Roth IRA to allow the power of compounding to work its magic, the Roth IRA affords you some financial flexibility in case an emergency arises.
The maximum yearly contribution amount for a Roth IRA is $5,500 for filers under 50 and $6,500 over 50. There are also some income restrictions for individuals wishing to contribute towards a ROTH IRA. For a complete list of income ranges eligible to contribute check out the following link (http://www.schwab.com/public/schwab/investing/retirement_and_planning/understanding_iras/roth_ira/contribution_limits). If Ryan maxed out his Roth IRA every year until he retired he would have an extra $1,120,424.14 in TAX FREE savings. This total coupled with his 401k account would leave him with $3,007,750.35. Can you imagine having 3 million dollars in the bank by the time you are 65?
Putting it into action
After working at your company for a particular time frame, your employer may give you the option to contribute to your 401k/403b. Ask your employer if they offer a match to your contributions and if so be sure to set aside at least that amount as your minimum investment. After you have gathered this information it’s time to start contributing. Sit down and see how much you can contribute each paycheck to go towards your retirement account. Usually you can specify a percentage of your pre-tax income or a specific amount each month.
If you can’t afford to put much away right now it’s OK but it’s important to at least contribute enough to meet your employer match. Finally, ask someone in your HR department to guide you through the process of setting up your contributions. This will help ensure that the setup is done correctly and that you begin contributing immediately.
Once your 401k/403b matching contributions have been set aside, it’s time to start contributing to your Roth IRA. Similar to a 401k/403b, you can select a percentage or amount you want to contribute from each paycheck. If your employer does not offer a Roth IRA here is an article with some great options to get you started (http://www.thesimpledollar.com/roth-ira-vs-401k/). Once you’ve selected your independent Roth IRA, be sure to set up an automatic transfer from your account each month. It’s important to periodically check up to see that you are reaching your 401k/403b and Roth IRA contribution goals for the year.
Bringing it all together
Having heard that his HR department offered a 401k option coupled with a Roth IRA, Ryan immediately emailed his HR department to start the process of getting his retirement contributions set up. Since his employer matched up to 6% of his salary, Ryan immediately began contributing to the 401k/403b and deferred contributing to the Roth IRA until he had hit his 6% match. Once he hit the 6% match, he began contributing a portion of his total contributions towards his Roth IRA account. Ryan now rests a little easier knowing that he’s setting himself up for a relaxing and financially independent retirement.
Your retirement is an important life event you need to start planning for. A 401k/403b coupled with a Roth IRA offers you a tremendous opportunity to become financially independent in retirement. The first step to achieving this level of financial independence is by starting to put away money in these options right away. Even if it’s a small amount to begin with, contribute and allow the power of compounding to be your best friend. Is there any other information on the subject that you think others would benefit from hearing? I would love to hear your feedback.
My book recommendation for this blog post is “The Richest Man in Babylon” by George Samuel Clason. This classic novel gives financial advice that has stood the test of time and uses engaging parables to enforce its points. This is one of the great financial novels of all time and I highly recommend it. I have provided the link to the book below: