Now that this retirement party has wrapped up it’s time to get to the good stuff, as you know the real party isn’t until the after party anyway. Mr. 401(k) and Roth IRA have had enough Red Bull vodkas to stay up all night and they have roped us into a late night post party conversation we never intended to be apart of. But, no fears, the data they are about to give is extremely valuable and it would be wise to listen carefully. They are going to explain why you need to be investing in a retirement account, specifically a 401(k) or Roth IRA (don’t worry all the data has been fact checked by myself and I’m sober as a stone).
Why invest in a 401(k)?
*If you need a quick refresher on how the 401(k) works check out my 1st retirement party post here, I will proceed assuming the basics are understood.
The best and most concise way to explain why you need to be investing in your companies’ 401(k) plan (if offered) is through and example, so let’s jump right in!
Jillian has just started her 1st job after graduating from UCF, as an entry-level business analyst at IBM. The company offers a traditional 401(k) plan with a 5% match and Jillian is trying to determine if she should save on her own, say at her local bank, or partake in the 401(k) plan. To help make the decision she has set up an analysis of the two options.
Before she completes the analysis she writes down the key figures needed to project her future account value in each scenario.
- Gross Income: $45,000/year
- 401(k) match: up to 5% dollar-for-dollar
- Average stock market return: 8%-12%
- Savings time horizon: 35 years
- Local savings account interest rate: .25%
If Jillian decides to take advantage of the 401(k) plan she will contribute up to the maximum match of 5% or $2,250 per year. Since IBM will match that 5% dollar-for-dollar they will also contribute $2,250 each year for a total annual contribution of $4,500. To keep the analysis simple Jillian assumes she will not get a raise over her savings time horizon, meaning her 401(k) contribution will be the same each year.
She plans to invest the 401(k) funds into the general stock market where average returns are usually between 8%-12% per year, but she will be slightly conservative and use the assumption of a 7% average market return per year.
Knowing this information Jillian can project what her retirement account value will be at the end of 35 years. After the math is complete she determines her 401(k) account will be valued at $665,611 and out of that amount only $78,750 had to come from her own pocket! Her employer contributed $78,750 and the remaining $508,111 is the projected return from the market. (Image of math can be seen here)
Looked at another way her return is almost 745% over 35 years or an average of 9.97% a year, not bad. Taking into consideration the likelihood Jillian’s salary would increase and the market return may be greater than 7% this could a very wise retirement investment!
Local Savings Account Projection
The other option Jillian has, is to save 5% of her income each year on her own at a local bank, in a traditional savings account, with an average annual yield of about .25%. If she were to choose this option after 35 years she projects an account value of $82,396 which out of that amount she would have had to contribute $78,750 from her own pocket (the same amount she otherwise would contribute to the 401(k)).
Now that the analysis is done it is easy to see there is no comparison, it should be loud and clear that the 401(k) is the superior savings vehicle for retirement. Jillian has projected she would have $583,215 more in a 401(k) retirement account compared to a traditional savings account, even with the exact same contribution amounts. This example illustrates the power of the employer match but more so the power of compound interest over a long period of time, two factors not to be ignored when planning for retirement.
Why invest in a Roth IRA?
*If you need a quick refresher on how the Roth IRA works check out my 2nd retirement party post here, I will proceed assuming the basics are understood.
Just as the 401(k) the best way to explain why you should be using a Roth IRA for retirement saving is though an example, so let’s rejoin Jillian a few years later.
Jillian has been working for a few years and decides she wants to save additional money for retirement outside of her 401(k). She could save in a traditional savings account but has already determined that for long-term growth that is not the ideal savings strategy. She knows stocks can provide greater returns over long time horizons so she is considering either opening a Roth IRA or investing in the stock market using a normal brokerage account.
In either scenario she will invest $3,500 a year for a time horizon of 25 years into the general stock market and assume an average rate of return of 7% a year. In both cases her projected future account value is going to be the same, $236,868 (Image of math can be seen here). The difference between the two options will be attributed to the tax she has to pay on the capital gains from her investments once withdrawn.
With the Roth IRA she would pay no taxes and keep the total $236,868 as long as she didn’t access the funds before retirement. If she were to make these same investments using a normal brokerage account she would end up owing $22,405 in capital gains tax and keep only $214,463. While the results with the Roth IRA are less impactful when compared to the 401(k) example (mainly due to the company match) there is still a 15% difference between the two options and one clear winner, the Roth IRA (that is unless you prefer to pay more taxes).
Well, that will officially wrap it up for this retirement party. If you missed any of the action you can catch up on all the posts regarding retirement here. Hopefully you found this retirement mini series useful and educational. As always if you liked what you read or think others can benefit from this post please share it! Also, you can subscribe (look to the right) if you don’t want to miss a beat. Until next time I’ll leave you with this retirement mantra, save early and save often.