Find out how 401k and IRA plans work, and learn why choosing the Roth version could save you thousands of dollars.
Investing in traditional retirement accounts isn’t the only way to retire comfortably.
At Minority Mindset, we recommend creating your ideal lifestyle by doing something you love, then building wealth over time with smart investing strategies.
However, if you’re employed by a company that provides a 401k or Roth 401k, you may want to take advantage of it, especially if you can’t pass up the free money deposited by your employer’s matching contribution.
If you’re employed and want to take advantage of the 401k offered at your company, you can find out which options are best for Minority Mindset thinkers in this article.
Here’s what you’ll learn:
- What Is a 401k retirement plan?
- How traditional 401k retirement plans work
- How Roth 401k retirement plans work
- What is an IRA and Roth IRA?
- How to use 401k and IRA plans effectively
What Is A 401k Retirement Plan?
Please note: This article contains general information about retirement plans and taxes — but we’re not tax attorneys. If you have specific questions about your contributions, earnings, and taxes, please contact a licensed tax attorney in your area.
401k plans are employer-based retirement accounts.
If you work for a company that provides 401k benefits, it generally means that your employer will match your contributions up to a certain amount.
401k plans are easy for people who don’t understand financial planning because your employer deducts a percentage of your paycheck, then deposits it (along with the matching employer contribution) and goes straight into a retirement account.
Because the 401k is so easy and requires no real management, many people allow funds to be automatically deducted from their paycheck and deposited into their retirement plans — without actually understanding how the plans work.
Not understanding your 401k plan can lead to a significant loss of money over time.
Choosing the right type of 401k (traditional versus Roth) can have a significant influence on how much money you have in your pocket when retirement rolls around.
In the following sections, we explain how the traditional and Roth 401k plans work, so you can make informed decisions about your retirement funds.
How Traditional 401k Plans Work
With any type of 401k, a percent of your income gets deducted from every paycheck and deposited directly into an investment account.
The money you put into your account typically gets invested into mutual funds, which hopefully grow over time to build a retirement nest egg.
A standard 401k defers your tax payments (although it does not defer your FICA taxes).
Tax-deferred is not tax-free, though.
When you reach retirement age and are ready to withdraw your money, you’ll have to pay taxes based on the tax rates at that time — and that’s the “catch” to 401ks you must understand before you invest.
We have no way of knowing how much taxes will cost in ten, twenty, or thirty years.
What does this mean for you?
Imagine, paycheck after paycheck, year after year, you turn a portion of your hard-earned money over to a 401k account.
You sacrifice and contribute for decades, waiting until you hit the age of sixty so you can enjoy that big pot of money growing in your 401k.
However, when retirement time comes around and you go to the bank to collect your money, you may get the shock of your life and discover how little money is left after taxes — and how little it’s all worth due to inflation.
Let’s take a look at how your money can grow and shrink to the point of regret when you invest in a traditional 401k.
For the sake of simplicity, we’ll leave FICA taxes out of the example below.
Imagine you earn $50k per year as an employee.
You faithfully contribute 3% of your income ($1,500) to your 401k.
= $1,500 annual contribution
Your employer matches your contributions up to 3% of your income.
= $1,500 annual employer contribution
Total invested annually: $3,000 (tax-deferred)
Each year, you continue adding contributions to your 401k.
- Over time, you make a higher income, so you end up contributing a total of $100,000 to the 401k over your lifetime.
- When you add this to your employer contributions of $100,000, you end up with a total $200,000 saved in your 401k by the time you reach the age of sixty.
- In addition to your contributions, your 401k investments did pretty well, earning you another $200,000 over time.
Thanks to your contributions and your employer’s matching contributions, plus your 401k growth and minus all fees, you now have a total of $400,000 in your retirement account.
All your sacrifice and dedication paid off, and now, at sixty years old, you’ve got $400,000 to keep you comfortable and secure throughout your retirement. Right?
First of all, this is thirty or forty years down the road, so that $400,000 is probably worth about $120,000 in today’s money (assuming a 3% annual inflation rate).
Worse, you do not have $400,000 to retire on because you haven’t paid taxes on that money yet.
Even as you’re reading this, you’re probably doing the numbers in your head, thinking you’ll keep at least $250,000 or $300,000 of your $400,000 after taxes.
If you’re estimating taxes based on today’s tax rates, you better hang on to your hats (or turbans), because this next part may shock you.
You’ll pay the then-current rate of taxes (whatever the tax rates are when you withdraw the money) on your $400,000 retirement fund, before you withdraw your funds.
What will tax rates be when you retire?
We should never assume that today’s top tax rate of 37% is a guidepost for future tax rates.
Tax rates and policies can flip-flop depending on who wins a presidency, which party dominates the senate, or how the state and democracy of our country plays out.
In 1942, after the bombing of Pearl Harbor, President Roosevelt pushed for a 100% tax rate, believing that “no American citizen ought to have a net income, after he has paid his taxes, of more than $25,000 a year (about $300,000 in today’s dollars).”
Roosevelt’s tax proposal never went through, but top tax rates did rise to more than 90%, which is a good warning for anyone dropping their hard-earned money into a traditional 401k account.
- The Revenue Act of 1942 raised tax rates to 88% on incomes over $200,000 after the bombing of Pearl Harbor.
- By 1944, top income tax rates reached 94%.
- It wasn’t until 1981 when top tax rates dropped below 70%.
Signing on to pay a future tax rate, when the current rates are reasonable, is a mistake.
When tax rates are low, investing in a traditional 401k is a poor choice because you could potentially lose 50 – 90 percent of your investment to future taxes.
How Roth 401k Plans Work
Because tax rates are at a historic low (with 37% as the top tax rate, compared to 70+ percent rates before 1981), the Roth 401k is currently a smarter investment than a traditional 401k.
The Roth 401k allows you to pay today’s current rate on your contributions now, so you don’t owe taxes on that money when you retire.
With a Roth 401k, you pay taxes on your entire paycheck now so you won’t have to pay taxes on your 401k contributions in the future, when rates may be higher.
When you invest in a Roth 401k, you can generally withdraw your money, after the age of 59 ½, tax-free.
- With a traditional 401k, you saved taxes on $1500 of your paycheck each year, which means you were taxed on $48,500 annually.
- With a Roth 401k, you pay income tax before you make contributions. This means you pay taxes on your entire $50,000 salary, no matter how much you contribute to your Roth 401k.
Even with a Roth 401k, your employer’s portion of the contribution is not taxed, so you’ll still need to pay taxes on that portion when you retire.
Let’s take a look at what your contributions and taxes might look like with a Roth 401k.
Since you’re paying taxes on your investment into your Roth 401k, you’ll probably make smaller contributions along the way.
Please keep in mind this example does not include FICA deductions, which always come out of your paycheck when you get paid.
For example, imagine you open a Roth 401k and contribute $90,000 over the course of your lifetime instead of $100,000 (to help offset the income taxes you pay now).
Then, your employer matches your contribution.
Over time, your investments grow.
Total value of Roth 401k at age 60 = $360,000
- Total tax-free funds available to you: $270,000
- Amount subject to current taxes at the time of withdrawal: $90,000
At first glance, this example seems to leave you with $40,000 less than a traditional 401k, however, you can generally withdraw all but $90,000 (employer contribution) tax-free.
You’re still risking potentially high tax rates on your employer’s contribution, but the Roth 401k allows you to significantly cut the risk of high taxing on three-quarters of your investment..
When tax rates are low (as they are in 2020), it makes more sense to invest in a Roth 401k. If tax rates spike up in the future, then a traditional 401k may be less risky.
What Is An IRA And Roth IRA?
An IRA, or individual retirement plan, is similar to a 401k.
IRA plans are accounts you set up at a financial institution, such as a bank, that allow you to set money aside for retirement while deferring income taxes on the amount you invest.
Roth IRA plans allow you to pay taxes now on the money you invest, so you don’t risk paying outrageously-high tax rates when you withdraw your money at retirement age.
Roth IRAs come with maximum income eligibility guidelines that change over time. For example, in 2019, the maximum salary for people wanting to open a Roth IRA was less than $122,000 for singles and $193,000 for married filing jointly.
Most IRAs allow you to choose your own mutual funds, and you can opt to hire an investment manager to advise you or make decisions for you.
How To Use 401k Plans Effectively
If your employer is willing to match your Roth 401k contributions, it may be worthwhile to contribute to your retirement through their plan.
However, 401k plans should be used as a supplement to your retirement plan, not the sole source because there are risks involved, such as:
- Investing all of your retirement funds into one type of asset is a risky, unsafe, strategy.
- The fees can be very high.
- Tax consequences can be unpredictable.
Any type of investment comes with risk, and Minority Mindset thinkers know that building wealth over a lifetime, through multiple income sources, is the only way to truly protect and care for the future of you and your family.
By supplementing your 401k and IRA plans, you can work toward ensuring that you’ll have enough money to live on during your retirement even after the cost of inflation affects the value of your retirement package(s).
Understanding how money works and how to build wealth helps you build a more secure future, not only for retirement but also for living a good quality of life before you reach age 65.
Stock market investing, real estate investing, and entrepreneurship are three of the most popular ways to build wealth over time.
Stock Market Investing
Low-cost Index funds can be an excellent passive investment. When your stocks increase in value, you make money.
- Stocks can be an excellent form of passive investing.
- If you continually reinvest your earnings over time, you can multiply your investments and build a long-term wealth.
- You can build a diversified investment portfolio and avoid putting all your money in one place.
- You have access to your money whenever you need it, even when you’re younger.
- The price of investing (costs and fees) is very low compared to other forms of investing.
- Stocks are a long-term investment that require time (usually decades) to build wealth.
- Some risk is involved, although investing wisely with a non-emotional approach can greatly offset your risks.
- Your investment and profits are vulnerable to dramatic market changes. Unforeseen rare events and catastrophes, such as a plunging national economy, can cause you to lose money quickly. Their value will typically rise back up over time if you are patient.
Stock market investing can be an excellent way to build wealth for the future, and it doesn’t cost much to get started. To find out how you can get started on just $10 a day, check out our guide:
Real Estate Investing
By purchasing investment properties and renting them out to other people, you can earn excellent profits to build wealth over time.
- Allows you to build a sizable passive income at any age.
- Can potentially generate high earnings in a short amount of time.
- Tax breaks allow you to grow your money to grow tax free.
- Dual earnings potential: you can generate profits from rentals and also earn money when your investment property increases in value.
- Requires a learning curve to understand what properties to purchase and how to manage them successfully.
- Requires taking risks on investment properties and on the health of the real estate economy.
Real estate investing can be an excellent way to build wealth now and for your future. To learn more about how to get started, check out our getting-started guide for beginners:
For many people, entrepreneurship is the best way to dramatically increase earning potential and generate income for retirement.
- Own your own business.
- Enjoy unlimited earning potential
- High earnings potential at any age
- High risk investment for new entrepreneurs, but the risk is lowered as you persistently learn and experiment.
- Time consuming in the beginning, but you can build business models that require less of your time down the road.
- Requires personality traits that you may need to develop, such as persistence, tenacity, and determination.
Entrepreneurship provides many people with the income and lifestyle they dream of throughout their lifetimes. If you’re willing to take risks and constantly be learning, it may be an excellent way to invest in your future.
Using 401K And IRA Retirement Plans To Your Benefit
When you understand how 401k and IRA retirement plans work, you can use them as one of the many ways to build wealth for your retirement.
Combining your 401k/IRA plans with other forms of wealth-building, such as stocks, real estate, or entrepreneurship, can be an excellent way to build a solid retirement strategy.
If you decide to invest in a 401k or IRA, keep in mind that the Roth versions allow you to pay taxes now so that you don’t risk your investment to uncertain future tax rates.
If you need help developing a retirement strategy, check out our friends at Blooom. Their financial advisors can advise you on how to build and create a solid investment strategy to help you reach your retirement goals.