If you have already maxed out your retirement accounts for 2018, congratulations! Give yourself a pat on the back. If you haven’t yet, watch the video or read on to see how much you can save.
I’m not suggesting that you try to pinch pennies, save more or don’t buy those holiday gifts. If you have money in taxable accounts or maybe an extra balance in your checking/savings account that you’ve carried all year – you can spend $1,000 from that account and put a corresponding $1,000 into your retirement account [employer 401(k) or personal IRA]. It makes a big difference over time.
What’s the big deal?
It’s just a little tax, right? Remember, it’s not what you have (or earn), it’s what you get to keep. Let’s crunch the numbers. Scale the following up (or down) based on your situation, but here’s a very simple example. Let’s start with the assumptions: 5% return / year (3% growth and 2% dividend), $1,000 initial investment, 24% marginal tax bracket, 20 year time-frame, re-investing the qualified-dividends (taxed at 15%) each year. Your experience may vary (significantly) from this simple example, so scale up or down.
$1,000 grows to almost $2,800 by the end of 20 years (start of the 21st year). That’s awesome. But wait, depending on how it grows, you might owe the government some of that money – remember they want their cut too!
So, let’s assume we have this growing in a taxable account, as an investment in a mutual fund, or ETF. During those 20 years, you have both growth (3%) and dividends (2%). The qualified-dividends are taxed at capital gains rate (15%) each year and the growth is also taxed at 15% when you sell.
From the example, instead of the $2,800 that we enjoyed, we only get to keep $2,468 when this money grows in taxable account. That’s too bad. Is there a way we can keep the whole thing? Enter: Roth. Both Roth 401(k) accounts and Roth IRA accounts allow you to put in after-tax dollars (the same as those in your taxable brokerage account), grow it tax-free and take it out tax-free at the end! How cool is that? So in a Roth account that same $1,000 grows to the $2,800 and when we spend it 20 years later, we get the whole $2,800.
What this means?
If you have yet to max out your retirement accounts for 2018, and you have a brokerage account, or some “extra” balance in a checking/savings account that you’ve had all year, you can do the following:
- Spend $1,000 from your brokerage / checking / savings account
- Put a corresponding $1,000 from your paycheck into your retirement account by
- Calling up your benefits department and having them take it from your paycheck
- Logging into your personal IRA and adding it to your account (in this case, don’t actually spend it in step 1 above!)
For the 15 minutes of work this month, you’ll gain over $300 in the future. Not bad.
How about a Traditional 401(k) or Traditional IRA?
The same math (essentially) works in a traditional 401(k) or IRA. The difference is:
- You call your employer (or click in your IRA) and put in $1,300 instead of the $1,000.
- You get to deduct this on your taxes and so save $300 in taxes (24% marginal rate) making it equivalent to spending that $1,000 from your brokerage account
- The $1,300 grows tax-free over 20 years, leading over $3,600 in funds! But wait, you owe taxes now.
- When you take it out, it’s taxed at your current rate. Let’s assume 24% marginal, but it might well be less in retirement.
- You get the same amount: $2,800. See table below.
Get it Done
So go ahead and call your benefit department or do those few clicks online to maximize your retirement accounts. Your future self will thank you (big time!)
Notes on the Assumptions
- 5% return may be high or low, I have no idea. History says stocks grow at more like 10% / year, but we may be in an environment where the future looks more bleak than that.
- 2% dividend is about where the S&P 500 is right now.
- I used 20 years. Longer time and/or higher returns add up to even more savings!