This is Alpha, the first-born, when he was 2YO.
This is Beta, the second-born, when he was about 2YO.
This is Gamma, the third-born, when he was about 18MO.
The Magic of Confounded Interest
Feb
25
2008
I had a meeting with a personal financial representative and he told me I was saving too much money in my 401(k).
His recommendation to me was to contribute only the minimum amount necessary to get all available company matching for the 401(k) then take the difference from my now extra take-home pay and put it into a Roth IRA. The reason was to pay less in taxes. His question was “Would you rather pay taxes on small contributions or on the large sum that you’ll have in retirement?”
Here is an example to show how it works. Note that the numbers used are general figures.
Round numbers: Someone make $50,000 a year. He contributes 7% of his salary, making that $3500 a year. $3500 invested for 40 years at an average return of 10% = $1,700,000. Isn’t compound interest great?
Now he contributes 3% of his salary, making that $1500 a year. This hypothetical individual wants to keep some money going into his 401k in order to get his company’s matching contributions. He takes the extra $2000 after taxes and puts it into a Roth IRA. His total investment over 40 years is going to be the same, $3500 a year for 40 years.
But the tax amount is what differs. His total return in the first part was $1,700,000. That is not going to be taxed until he retires, so he’ll pay 15% on $1,700,000 (assume he drops down one tax bracket in retirement). Total taxes = $255,000 at a minimum (his funds would continue to grow during his retirement, but this is a simple example).
His taxes in the second part are going to be 25% of $2000 a year, or $500. $500 for 40 years equals $20,000. After he retires, his Roth IRA withdrawals are tax-free. “So,” the representative said after showing me a fancy graph, “would you rather pay the government $20,000 or over 10 times that?”
If one’s goal is to help fund the government, then one can keep maxing out one’s 401k. For the other strategy to work, one need to be disciplined enough to fund the Roth IRA one’s self. The other question is this: would the government rather have a little money now or a lot of money later?
If the government compounds $500 a year for 40 years at a 10% rate, it would end up with $243,000, which is pretty close to what it would get later. So at the end of it all, it would seem to be a wash: the government could end up with $250,000 either way. But one way, the individual pays the entire amount; whereas the other way, the government has to invest a smaller amount and earn the full amount.
To see how much he has at retirement, he could take the $1.7 million and subtract taxes from the 401k withdrawals. In the first case, the withdrawals would have taxes of at least $255,000. In the second case, he has to see how much of the $1.7 million comes from the 401k and subtract those taxes. He could also see how much extra taxes he would pay because his take-home pay is larger going with a Roth IRA. So if he went with a full 401k and invested the extra take-home pay in a Roth, what would be the effect of that?
The advisor’s point was that I should reduce my 401k contributions and do more with my Roth IRA. His motivation behind compelling me to do that was mostly because he had some mutual funds that would be just right for my Roth IRA, I think. In case you are wondering how things ended: I did not move any of my 401k into his mutual funds.
The example was a little simple, as it does not take it to account a lot of factors: the higher take-home pay due to reduced 401k contributions will result in higher income tax, maybe I would rather have $500 a year now at the expense of future money, will Roth IRA rules change in the future?, how much would inflation cause that $225,000 tax bill to be in today’s dollars?, etc.
How much should you put into your 401k? How much should you put into a Roth IRA? I don’t know. I am not a financial advisor nor do I play one on TV. Any information on this site is general in nature and is not intended to be financial advice for your specific situation. I recommend that you discuss any tax, investing, or other financial items with a professional advisor.
“Know well the condition of your flocks, {And} pay attention to your herds; For riches are not forever, Nor does a crown {endure} to all generations.”
– Proverbs 27:23-24
