Rule 2 of 3 for Retirement Investing:
- Put your money where it averages the greatest returns long term (10+ years)
- Treat retirement accounts as insurance for not having money when you’re old
- Passive indexing and rebalance periodically
Imagine that you’ve managed to build a considerable amount of wealth throughout your career. Maybe you have $3M in the bank earning interest or several rental properties earning passive income. Maybe you’ve gone into commercial real estate or some startup stock options paid out. I like to believe I will still be earning money through my late years through one thing or another. In this scenario, does it even matter that I have retirement accounts? No, it probably doesn’t matter to me and my lifestyle if i’m still earning income in my late years. It does matter to my net worth, but I really just need enough for me and my family to get through.
But what if things don’t work out…
I’m pretty optimistic, but the reality is a majority of Americans are ill prepared for retirement. At the end of 2016, there was a record 10.8M millionaires in America. That’s a record high, but that’s only 3.4% of Americans. Also 1M in my opinion is not enough to live off of.
If i’m still making money in my golden years, then having money in my retirement accounts is just icing on the cake. When I really need money in my retirement account is when shit hits the fan and all the investment and plans I made in my life end up worthless and I need to live off of my retirement accounts.
Corollary 2a: You need your retirement accounts the most when you aren’t making money in your golden years.
Taxes now or Taxes later?
There are many types of retirement accounts people use: 401k, Roth 401k, Traditional IRA, and Roth IRA. There are other types of accounts, but besides having different restrictions on how much you contribute to each year and income restrictions, the main difference is contributing your money “pre-tax” or “post-tax”.
What that means is do you want to pay taxes on your contributions now at your current tax bracket (post-tax contribution) or later in retirement when you are making withdrawals (pre-tax contribution)? My answer is pay later because, we are planning for the situation where we aren’t making much money in the future and therefore we will be in a lower tax bracket in the future, therefore paying less tax overall.
Tax Deferral is a benefit you can get from a retirement account like a 401k. It means, that the money you put in your 401k is not taxed now, but when you withdraw it later in retirement. This is a great benefit if you’re down in your luck in your older years. If you’re pulling in a good income now, you may be in a pretty high tax bracket like 25% – 28% and possibly you’re paying like 9.3% state taxes as well.
Pre-tax (deductible) Contribution
Pre-tax, also called “deductible” means you contribute money to an account BEFORE you pay income tax on it. Let’s say you make $100k a year, and if you stash $10k in your 401k, you’re saving like 37% (~$3700) in taxes now. Your take home pay is also $6300 less a year (ouch) but you got to think big picture. Later, when it’s time to take out money from your 401k, you have to pay income taxes on that money (hence tax deferred), but if you’re not making much money in your golden years, you’re gonna be in a lower (10-15% bracket). If you’re pulling income late in your years, it doesn’t really matter if you gotta pay taxes on your income, because you’re making money, and you’ll be fine. This is why I believe in funding a 401k over a Roth IRA, but if possible, you’ll want both.
Corollary 2b: The philosophy is escape high taxes during your money making years and pay them when you’re retired, making less income, and in a lower income bracket.
Post-tax (deductible) Contribution
Sounds like pre-tax is the way to go. Why should I contribute post tax? Basically there are limited options to contributing pre-tax and when those options are exhausted and you have more money to contribute, then post-tax contributions with tax deferred status is not a bad option.
You may have heard about this very popular retirement account called the Roth IRA. It’s famous because even though you have to put in post-tax money (non-deductible), you don’t have to pay taxes on the growth of the account! That’s unheard of in the ears of Uncle Sam! I would recommend contributing to a 401k before the Roth IRA, but once you max out the 401k, putting money in the Roth IRA is next.