By: Devan Robinson
“Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.” – Albert Einstein
Modern investing seems to get more complex by the minute, and the financial industry tries its hardest to make investing language as incomprehensible as possible. Most people have heard of a 401(k). They know someone said they should contribute to it, but honestly they aren’t sure why. The same goes for an IRA. But what’s the difference between those two options? Who is Roth, and what does he have to do with IRAs?
A goal of Fairlead Financial’s blog is to tackle one financial concept at a time. We want to simply financial terms and concepts to help you, our clients, understand this complex industry. This week I would like to discuss the most common types of retirement accounts. What is a retirement account and why on earth should you want one?
A retirement account is just that - an account. It is not an investment, it is not an interest rate, it is simply a bucket that can hold wealth. Many of you probably have “buckets” already – a checking and a savings account. A retirement account is just another bucket that you can deposit wealth into, and it comes with unique advantages over those checking and savings accounts.
One of the most common retirement accounts is the 401(k). A 401(k) is an account offered by an employer, where you can elect to have some of your paycheck deposited each pay period. If you are lucky, your employer may elect to match your contribution. This is one of the rare instances where you can earn free money- take advantage of it! One of the biggest advantages of a 401(k) is that the money you deposit into your 401(k) is tax-deferred until you retire. Essentially, what you deposit you delay paying income taxes on. This is a big deal because more of your money goes to work for you rather than the government.
One of the drawbacks of a 401(k), however, is that you are at the mercy of your employer when it comes to investment options and fees. The investment options through a 401(k) can be limited. Your employer will typically offer 10-20 different mutual funds for you to choose from, you then decide where among those options to invest your contributions. In our experience that can be a good or a bad thing; we have seen exceptional and terrible offerings. Regardless of the options however, we feel that generally you should always take advantage of the free money your employer offers by matching your contributions.
A Traditional IRA (Individual Retirement Account) is similar to a 401(k), it is a tax-deferred account for your wealth. The difference, however, is that an IRA is self-directed, not employer directed. You have full control over it. In an IRA, you get to pick your investments from nearly anything. You can invest in individual stocks, bonds, ETFs, mutual funds, closed-end funds, commodities, etc. This is one of the reasons we typically suggest our clients consider opening an IRA if they are limited to a sub-par 401(k).
A Roth IRA is yet another type of retirement account. It operates much like a traditional IRA, but you pay taxes upfront rather than defer them. In a traditional IRA or 401(k) you will pay taxes when you withdraw your investments; when investing in a Roth IRA, you pay your taxes when you invest and are not taxed when you withdraw your investments down the road. As a result, you accumulate tax-free income for retirement, or for your heirs. The choice between the two usually comes down to your view on your individual tax situation. Do you foresee your tax-burden being higher or lower when you retire? If you anticipate a higher tax burden down the road, a Roth IRA could be a great idea to consider.
Why does this matter?
Why does all of this fuss over deferring taxes matter? Compounding. Albert Einstein was not joking when he said that compounding interest was the eighth wonder of the world. Many investors understand the concept of compounding returns, but may not realize that compounding also applies to your fees and taxes. A core tenet of our investing philosophy at Fairlead Financial Group is to encourage our clients to consider not only the amount they “earn” at the end of their investment horizon, but to also be cognizant of the amount of taxes and fees they incur. Our goal is to understand and focus our efforts on how much money you will be left with at the end of the day, after fees and taxes. Not simply the annual return on your investments.
By investing in retirement accounts, not only can you lower your income taxes, you also do not have to pay capital gains tax inside of your retirement accounts. In a typical, non-qualified account (such as your checking/savings or a normal brokerage account) you will pay taxes on any gains that you make (generally 20% of the capital gain). Those taxes matter, especially when compounded over a long period of time. Rather than bombard you with the math, J.P. Morgan does a great job of illustrating this effect below:
Past Performance is no guarantee of future results. Indexes are not available for direct investment.
Assuming a 7% rate of return over 30 years, even an investor in the 33% tax-bracket at retirement can save an additional $60,000 after taxes. That is the net/net effect to your wealth’s bottom line. What rate of return you achieve with your investments is definitely important, but so is keeping as much money as possible at the end of the day.
There are some key details to consider when deciding how best to invest in a retirement account. For many retirement accounts, such as the 401(k) and Traditional IRA, there are penalties for withdrawing prior to age 59 ½ . Be sure that the wealth you invest in these accounts can be set aside until you are retirement age. There are also specific rules regarding required minimum distributions starting at age 70 ½. In addition to that, there are contribution limits and there can be limitations based upon your income. In short, contact us before investing in a retirement account so that we can ensure that it is appropriate for your situation.
Modern investing is complex, confusing, and frankly not always geared toward an individual investor’s success. At Fairlead Financial Group, we work every day to simplify investing and financial planning for our clients, and help navigate them through these complex financial markets. Contact us today to determine if investing in a retirement account is right for your family.
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