Bet you weren’t ready for that.
Neither was I.
Early in my professional life, I thought retirement accounts were boring.
My thinking then: Who would want to put money in an account that you can’t touch until your 65?
My thinking now: I would!
Over the years, I’ve been incredibly fortunate in that I have been a part of two separate startup companies that were acquired by larger companies.
Both times I got a fairly sizeable check in exchange for the company stock that I owned.
Both times as well, I had rather hefty tax bills. I had never thought of just what a dramatic bite of your income goes to taxes until I saw taxes at that scale.
This gave me a new perspective on the benefits of retirement accounts.
What if all that tax (or a large chunk of it) had gone to my pocket instead?
Well, with a retirement account it does.
Before we dive in, here’s a quick overview of what it will cover:
- 2 Reasons why retirement accounts can’t be beat as investment vehicles
- Why I prefer the Roth over the Traditional option
- Determining what restrictions apply to you
- How to pick a brokerage and individual funds for your account
- Five straightforward takeaways
The Dynamic Duo: Compound Interest and Tax Savings
The flaw in my initial reasoning was that I wasn’t thinking big enough.
I was thinking in terms of thousands of dollars now, not hundreds of thousand dollars or even millions of dollars later.
It reminds me of the line from The Social Network when J. Timberlake (Sean Parker) says to Jesse Eisenberg (Mark Zuckerburg),
“A million dollars isn’t cool. You know what’s cool? A billion dollars.”
Retirement accounts are cool because thinking big is cool.
The first great attribute of retirement accounts is that they force you to think long-term about investing.
You can’t take money out until you are retirement age without severe penalties. (Yes, there are a few exceptions).
Long term investing offers the huge benefit of compound interest.
Compound interest is a simple principle:
- You have money in a savings or investment account that gains interest
- That interest is added to the total amount of money in that account
- Now you are gaining interest on your initial investment plus the interest that it has earned to date
- The cycle continues
Over a long time horizon, this cycle can snowball to the point where the majority of the money in the account is from interest (money you didn’t work for) as opposed to the hard earned money that you put in the account.
Let’s say I’ve saved a little over $3k in each of the last three years and have $10k to invest in retirement.
I went to Dinkytown.net and took a look at what would happen if I invested $10k now (at age 31) now and didn’t touch it until age 65 (retirement age).
I assumed a modest annual return of 7%. I also assumed that I never added another penny of my own investment.
That $10k would be worth $100k before taxes.
(BTW, $100k would become $1 Million in the same scenario.)
If my brother (age 25) made the same $10k investment and never added another penny, he’d have $150k.
6 years of compound interest with no extra investment nets an additional $50k!
With compound interest, you get HUGE benefits for investing now as opposed to later.
You may not have a ton of money to put into retirement now. However, I can guarantee you that you will never have more time than you do now.
So figure out a way to put something, however small, into a retirement account.
The other huge benefit is tax savings.
Retirement accounts let you avoid paying taxes on that investment either now (in the case of a Traditional IRA or 401k) or later (in the case of a Roth IRA or Roth 401k).
That’s free money in exchange for the commitment to take a long-term approach to investing. Can you say “win/win”?
Remember that $10k that became $100k with compound interest?
Well, it’s actually only $57k after taxes if it’s been growing in a taxable account. However, if it’s been growing in a tax-free Roth IRA that $100k is still $100k.
That’s right. You get to keep it all. You’ve just made another $43k, simply by taking advantage of a retirement account.
(BTW, that would be $430k gained if the starting balance was $100k).
When in Doubt Choose Roth
There are two flavors of tax-free when it comes to retirement accounts, Traditional and Roth.
Traditional IRAs and 401Ks allow you to invest tax-free dollars now. When you withdraw the money later, you pay taxes at whatever the tax rate is for your income bracket at that future time.
Roth IRAs and Roth 401Ks require that you invest post-tax dollars now. However, there are no taxes to pay later when you withdraw money.
In many cases, it’s toss up as to which type of retirement fund will maximize your investment. The most important thing is to invest in any retirement account.
Traditional IRA Benefits
Some people argue that there is benefit to the Traditional flavor.
Since the expectation is that you won’t be working at retirement, it is possible that your current tax bracket will be higher than your retirement tax bracket.
Therefore, you in effect get to invest tax free in a high tax bracket and then get taxed later in a lower tax bracket.
Roth IRA Benefits
I personally prefer the Roth option for a number of reasons- not all financial.
The investment limits for the Traditional and Roth options are the same. However, maxing out the Roth option allows you, in effect, to invest more money into a retirement account.
If you invest $5,000 of tax free salary into a Traditional IRA, then you have put $5,000 of salary towards retirement.
On the other hand, if you invest $5,000 post tax salary into a Roth IRA and your tax bracket is say 25%, then you have just invested $6,667 of salary into your retirement account.
Boom. Financially, that’s a pretty compelling reason to choose Roth.
No one knows what the taxes will be in 30 years. It’s very possible that tax rates will increase.
I love the peace of mind that comes with knowing that my taxes have already been paid, and all of the money that remains in the account is mine to keep.
When planning, there is one less unknown variable as I don’t have to account for what my future taxes might be.
I don’t plan on retiring. I plan on doing meaningful work until I die. I also plan on making more money as I get older.
I can’t guarantee that I’ll be a higher earner than I am now. Still, increasingly there are plenty of examples of people just hitting their stride in their 60s.
Do you qualify?
It’s important to note that there contribution limits and income thresholds that apply to Traditional and Roth IRAs that can change from year to year.
Before you open an account or contribute to an account brief yourself to make sure that you qualify.
If you have an employer 401k, talk to your employer about any restrictions.
Remember to ask them if you have a Roth 401K option.
It’s like a Roth IRA, just with MUCH higher contribution limits. And you can roll it into a personal Roth IRA when you leave your employer.
Picking a Broker and Funds
So you’re becoming convinced that retirement accounts are indeed sexy.
Now you want to set one up and pick which funds to invest in.
With retirement investing, as with all investing, my thinking here is simple.
There is really only one factor that you know you can control when picking funds and a brokerage: fees.
It’s rare that any broker or fund well outperforms the market for any long period of time (15+ years).
Therefore statistically, it’s highly unlikely that paying higher fees will net you more returns. It’s just going to cost you more money.
Pick a broker that offers no-load mutual funds. This simply means that you are not being charged when the fund buys or sells various individual stocks.
Pick a broker that offers funds with low expense ratios (less than 0.25%). Expense ratio is a percentage of your investment that goes to administrative and operation fees. The industry average is north of 1%.
Pick a fund (or funds) that you can set and forget. Target date retirement funds are perfect for this.
You simply pick your targeted retirement date and the fund manages itself- it gets less aggressive as you get closer to retirement age.
This strategy allows you to do the research up front and then not have to worry about much going forward, except for getting more money into the account.
Where and how do I invest my retirement funds?
I have my retirement accounts at Vanguard in their Target Retirement Fund.
I chose Vanguard because they specialize in no-load, low-expense ratio funds. T. Rowe Price is another good option for these types of funds.
I can’t control what the market does over the next 30+ years.
However, by picking a low-expense ratio fund that is intended to pretty much mirror the US stock market, I can be very confident of two things:
- I will pay as little in fees as possible
- I will do (just about) as well as the market
Here’s a visual of the fees that I would save by choosing a Vanguard fund over industry average funds. (I assumed $20k invested now with an 8% annual return over 30 years.)
$47k saved just for picking the right brokerage. (On 100k investment that would be nearly $470k saved.)
Get Sexy With It!: Five Takeaways
So here are five takeaways that will ensure that you’re (still) sexy at 65:
- Prioritize retirement accounts as your first stop for investing.
- Get started. Even if its a tiny investment. You’ll never have more time than you do now.
- When in doubt, choose the Roth option.
- Pick a broker that offers no-load, low-expense ratio funds (like Vanguard).
- Pick a fund that you can set and forget.
How about you? Do you consider retirement accounts sexy? What barriers do you face to contributing to them more aggressively?