For years (over 12 to be exact), I did not save a single dime in a 401(k) plan. I thought I had good reasons for not doing so, but I recently sat down and really challenged my thinking on whether or not finally giving it a go would be a good financial move. After some number crunching, I finally came to the conclusion that I had made a big mistake by not investing in a 401(k) all these years. Allow me to take you through my thought process so that you can see that you too should starting saving in a 401(k) today.
Many people tout the 401(k) because of the presumed company match that accompanies arrangement. And of course, if there is free money to be had, it would be a bit foolish not to grab it. As a matter of fact, you could stop reading this post right now, start your 401(k), and be okay – you don’t need to know much more about why else you should start one. But not every 401(k) plan comes with a company match, and my 401(k) did not. Because of this I assumed that it was not worth tying up my money until age 59 1/2 with no match to show for it. I would be better off paying taxes now and enjoying tax free gains later in life! Unfortunately I did not fully test out my assumptions until recently.
Here was my logic, using the Roth IRA contribution limit for 2017 ($5,500) to illustrate. For simplicity, I’ll be using effective tax rates rather than progressive. I will also not be factoring in Social Security or Medicare taxes:
Roth IRA: After tax contribution of $5,500 with growth rate of 4% per year for 30 years = $18,224 <– Tax free money at retirement since the Roth IRA grows tax free.
401k: Pre-tax contribution of $5,500 with a growth rate of 4% per year for 30 years = $18,224 <– Have to pay taxes on both the contribution amount and accumulated growth. At a 25% effective tax rate, I would be left with $13,668.
Pretty simple. Obviously the Roth IRA wins out in the above scenario right? No! The above does not tell the full story. I should take into account three more factors:
I should factor in the taxes that would be paid on the Roth IRA contribution for a better apples-to-apples comparison.
I should not assume that my retirement tax bracket will be the same as my current tax bracket.
I should remember that I can contribute much more to a 401(k) than I can to a Roth IRA (Contribution Limit for 2017 = $18,000)
As a previously single man and now a married filing jointly man, I’ve been squarely in the 25% tax bracket for most of my working life. However, in retirement I doubt that I would remain in this tax bracket as I would not need as high of an income. Instead I expect to be in the 15% tax bracket during my golden years. I’m also in a position to max out my 401(k), so that higher contribution limit indeed needs to be a factor when judging the merits of both retirement vehicles. Let’s plug in the first two factors and take another look:
Roth IRA: Income of $7,333.34 –> (@25% tax rate) After tax contribution of $5,500 with growth rate of 4% per year for 30 years = $18,224 <– Tax free money at retirement since the Roth IRA grows tax free.
401k: Income of $7,333.34 –> Pre-tax contribution of $7,333.34 with a growth rate of 4% per year for 30 years = $24,299 <– Have to pay taxes on both the contribution amount and accumulated growth. At a 15% effective tax rate, I would be left with $21,249.15.
Without even factoring in the higher contributions that I’d be able to make into a 401(k), I still come out ahead. Let’s go ahead and add in the third factor.
401k: Income of $18,000 –> Pre-tax maximum contribution of $18,000 with a growth rate of 4% per year for 30 years = $59,643 <– Have to pay taxes on both the contribution amount and accumulated growth. At a 15% effective tax rate, I would be left with $50,696.55.
Taking all three factors into consideration, it’s very clear that I should prioritize the 401(k) retirement vehicle AND seek to max it out. This doesn’t mean that I will not use a Roth IRA period, just that I will prioritize maxing out my 401(k) before allocating money into Roth IRA.
In a future post I will discuss additional pros and cons of a 401(k) plan. However, the knockout punches of higher contribution limits along with the plausibility that I will be in a lower tax bracket in retirement really make a 401(k)the top retirement investment vehicle for me.