Have you wondered what the difference is for a Roth IRA vs 401k? This post will clearly break down how you can use compound interest, Roth IRA, and 401K to end up wealthy. Because who wants to work in retirement!?
Here’s everything you need to know and finally settle the Roth IRA vs 401K debate:
What Is Compound Interest?
Compound interest is loved by some of the smartest minds ever including Albert Einstein and Warren Buffett. It is commonly referred to as the 8th Wonder of the World. Compound interest is how you are able to retire wealthier than you thought possible. If our education system was smart compound interest would be an entire class.
If you want to earn the highest return on your portfolio you need to understand the importance of compound interest. By utilizing it you will be able to much larger net worth than if you invested into a savings account.
Compound interest is interest that is added to the principal of a deposit. The added interest can then earn interest.
Who benefits from compound interest?
Everyone! Seriously whether you are investing $100 dollars or $1 million dollars. Anyone can benefit, no need to be a wall street guru. If you invest in the stock market over time you reap the benefits of compound interest.
The longer your money compounds the more you will earn. Money that grows at 6% would double in 12 years. In 24 years it would be worth four times as much.
Why Does Compound Interest Matter?
If you had $1,000 initial investment and received 20% interest rate per year you would have the following balance.
Initial deposit: $1,000
- Interest rate: 20%
- 1st year: $1,200
- 2nd year: $1,440
- 3rd year: $1,728
- 5th year: $2,488
- 10th year: $6,191
- 20th year: $38,337
- 30th year: $237,376
This example assumes that you do not invest more than $1,000. After 30 years you would have gained $236,376 dollars or 23,637% increase.
This is the reason that you need to think LONG TERM instead of cashing out during a bad week or month in the stock market. Of course, few (if any) investments will return 20% over 30 years but is used to help illustrate the growth potential of a $1,000 investment.
How can you take advantage of compound interest? Will you make more money in a Roth IRA vs 401K?
ROTH IRA (Retirement is On the Horizon)
With increased housing costs, student loan debt, and lower wages retirement might feel like a pipe dream. But you still have to start saving early or you’ll regret it later. As the previous section showed, with compound interest the earlier you start the more you will be rewarded.
People generally seem to correlate investing for retirement with an employer-sponsored 401K or 403B. These are definitely the most common but there is another option that has more flexibility and lets you grow your money tax-free over time. This is known as Roth IRA (Individual Retirement Account).
Basics of a ROTH IRA:
- Money contributed is POST TAX earnings. This means the money has already been taxed (opposite of a 401K).
- If you’re under age 50, you can contribute up to $5,500 per year.
- If you’re age 50 or older, you can contribute up to $6,500 per year.
- This is an account that you open with a broker, it is not offered through an employer.
- Income Limits
- If you file taxes as single you can’t make over 117K/year or more
- If you file taxes as married you can’t make a combined salary of 184K/year or more.
Advantages of a Roth IRA
You can choose your investments!
With a 401K you’re only able to pick from a select group of funds that are assigned by your 401K provider. Unfortunately, most of them are high-cost mutual funds or target date funds with fees that will eat away your long-term gains. Sprinkled in are a few good low-cost interest funds but the selections are usually pretty slim.
With a Roth IRA, you get 100% choice of where to invest your money 🙂
The money grows tax-free
This is the opposite of your 401K. You won’t need to worry about what your income tax situation as you’ll shield yourself from any future tax changes. You would only pay taxes if you withdraw your earning before retirement age (59.5). This is one of my favorite reasons to use a Roth in the Roth IRA vs. 401k debate.
Diversify your taxes between retirement funds
When you retire you’ll have a 401K which hasn’t been taxed and a Roth IRA which has taxed.
You can pass it along
With a Roth IRA, you are able to pass it along to someone such as a significant other or child. There also isn’t a minimum withdrawal rate like there is with a 401K or Traditional IRA. You can choose to withdraw when you want!
Disadvantages of a Roth IRA
- Income limits. If you make too much money you are not eligible.
- Not tax deductible. 401K’s and Traditional IRA’s are tax deductible.
Overall I was able to come up with very few disadvantages because they are such a great retirement vehicle. But why do so few people have IRA’s? In my opinion, people don’t open Roth IRA’s for several reasons.
- The lack of awareness. Why isn’t this taught in school?
- Manual setup, unlike a 401K you need to set this up and contribute on your own.
- Can’t afford to save any more or intimidated by the whole process.
I think the biggest being reason is intimidation, I know it was for me. Even though I read several personal finance books that explained all the great advantages I still didn’t open a Roth IRA initially. As a typical twenty-something, I just put it off. There is no better time than now, the longer you wait the more likely you will be NOT open one and lose out on compound interest for your retirement!
Looking back these were the biggest questions that made me procrastinate when I first wanted to open a Roth IRA. Unfortunately, I procrastinated an extra year after first reading about it and cost myself some money.
Top Questions about Roth IRA’s
Why should I open a Roth IRA?
Tax-free gains, ability to withdraw your contributions anytime, and choice of investments.
Where do I open a Roth IRA?
Most brokerages let you open them for a minimal fee including E*Trade, Fidelity, TD Ameritrade and my personal favorite Vanguard.
How do I open a Roth IRA?
It’s surprising how easy it is, simply log onto the site you want to open your IRA and follow the steps. Get started with Vanguard in less than 10 minutes.
How do I contribute money to a Roth IRA?
Once you’ve opened your account you can deposit funds directly from a bank account. You can also set up automatic contributions on a recurring schedule.
What is the contribution limit for a Roth IRA?
As of 2018, the contribution limit is $5,500 if you are under 50 years old. You can add an extra $1,000 if you are 50 or older.
How do I decide what stocks, bonds or funds to pick?
With a Roth IRA, you can pick any investment choices, unlike your 401K with limited options.
As Vanguard states “Instead of hiring fund managers to actively select which stocks or bonds the fund will hold, an index fund buys all (or a representative sample) of the securities in a specific index, like the S&P 500 Index. The goal of an index fund is to track the performance of a specific market benchmark as closely as possible. That’s why you may hear it referred to as a “passively managed” fund.”
Roth IRA Compound Interest Example
- A 29-year-old makes $5,500 initial contribution.
- Forgot to invest anything, so the $5,500 sat in cash.
- Continues to make $458 monthly contribution ($458 x 12 = $5,500 = maximum annual contribution for Roth IRA).
- Invests for 30 years.
- Never withdraws money prior to 59 years old.
- Averages 8% annual return.
Total Contribution Amount: $165,000
Total Amount: $792,446.64
The other $328,192 was gained from compound interest! You only contributed 22% of the entire amount. Compound interest was the reason your investment more than quadrupled in three decades. A Roth IRA has already been taxed, so when you retire you are able to keep all $792,446 dollars.
This example was based on an 8% return, historical market returns are between 7-9%.
Here is the breakdown with 7, 9 and 10% returns.
- Example with 7% return: $603,387.45
- Example with 9% return: $919,498.68
- 10% is over a million dollars!
401K – The Most Popular Way to Retire
Basics of 401 K contributions:
- Money contributed is pre-tax earnings. Your This means the money has not been taxed and will in the future.
- If you’re under age 50, you can contribute up to $18,000 per year.
- Those age 50 and older can save even more by making what’s called a “catch-up” contribution. That’s limited to $6,000 a year, for a total of $24,500.
- Offered through your employer with no income limits.
- Limited investment options as the fund provider (i.e. Fidelity or another brokerage) selects whwat funds you can contribute too.
Your employer offers a 401 k plan and will typically contribute or match contributions. This is essentially free money and will double part of your investment.
For example, my old employer matched up to $1,000/year. Other employers match a percentage of your salary. The range is usually between a 3-6% match of your investment.
When you contribute to a 401K you will be investing money before it has been taxed. Naturally, you will invest more money than you would if it was post-tax like a Roth IRA.
If you invest 15% of your $2,000 paycheck you will invest $300 a pay period ($2,000 / 15). If you invested 15% after taxes it would be closer to the $190-$230 range depending on your tax situation. Remember you will be taxed in the future when you begin to withdraw your 401K. This is usually after you are 59 1/2 years old.
The last reason is that it 401K contributions will be automatically deducted from your paycheck. This way you won’t spend all of your paychecks and forget to invest, this is known as paying yourself first.
As I mentioned the 401K contributions are tax deductible so my gross, taxable income will be $10,000 less on my W-2. This will lower my tax bracket 3% and hopefully owe less (or nothing) to the government when I file my taxes. Stoked!
How do you stack up against others in your 401K savings? Take a look at the Vanguard graph below to see 401K balances by age & income:
401K Balances (by age)
401K Balances (by income)
Are you worried you can’t save any more or are barely contribute to your 401K?
Increase your percentage 1-2% and see if you actually notice a difference with your paycheck. As contributions are pre-tax you actually don’t seem to feel the hit as much as if it was post-tax. Once you become comfortable with your increase 401K contributions see if you can add another 1-2% until you reach at least 10% total monthly contribution.
What If You Maxed Out Your Retirement Accounts?
As of 2017, you’re able to contribute $18,000 per year to your 401K. In this example, we won’t even factor in an employer match as it will differ for everyone. Some employers will match a percentage while others won’t match any dollar amount.
- Starting Value: $0
- Annual Contribution Amount: $18,000
- Employer Match: $0
- Number of Years: 35 (ages 30 – 65)
- Average Rate of Return: 8%
401K Contributions: $630,000
Total 401K Value: $3,234,529
*Your money has not been taxed yet and will be when you begin to withdraw in retirement.
Your contributions are made with post-tax money. This means you have been taxed already and will not be again in the future.
- Starting Value: $0
- Annual Contribution: $5,500 per year
- Number of Years: 35 (ages 30 – 65)
- Average Rate of Return: 8%
Contribution Total: $192,500
Total Roth IRA: 947,74
Total Retirement Savings: $4,182,271
Think you can retire with a little over $4 million dollars? Not bad for just using two traditional retirement accounts.
Roth IRA vs 401K Recap
If you contribute to both a Roth IRA and a 401K/403B you are taking advantage of the two biggest retirement accounts. These accounts will help your savings grow faster and larger than a non-tax-advantaged brokerage account.
The more you contribute to your retirement savings accounts each year, the more money you will have in retirement.
Since it’s impossible to know what tax bracket you’ll be in at various stages in your retirement or what the tax rates will be in the future, it’s not a bad idea to have some retirement savings in a pre-tax (401K) and post account (Roth IRA). Then you can strategize your distributions to minimize your tax liability and essentially diversified your retirement holdings.
Don’t let a lack of planning when your young ruin your future.
Being a frequent golfer I get to meet a lot of people, especially older people. Anytime I meet someone “retirement age” I always ask them if they would’ve done anything different in their 20’s. Nine out of ten times I always hear how they wish they started saving earlier.
Use a 401K and Roth IRA to start funding your retirement plan and your future self will thank you. Remember act as if retirement is on the horizon.
Which one do you like more in the 401K vs Roth IRA battle?
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