Why You Might Be Contributing Too Much To Your 401(k)
Those who have been following Hello HENRYs for a while know that I am a HUGE advocate for 401(k) contributions. It is one of the single, most effective ways to get rich - especially if you start early - and to take care of future YOU. That being said, today's piece of advice may come as a surprise.
Once you contribute enough to reach your employer’s match, stop. I know it sounds crazy and I don't want you to stop forever, but don't continue contributing additional - unmatched - funds without completing one important step towards your financial freedom.
OPEN A ROTH IRA.
Okay, I hope I haven't lost anyone with that. Before I really invested (no pun intended) in my own financial knowledge, terms like "Roth IRA" made me want to run for the hills. Hearing those words made me feel so mystified and overwhelmed that I couldn't even think about pushing myself to learn more. Big mistake.
An IRA is just another form of saving for retirement, similar to a 401(k). In fact, it actually stands for Individual Retirement Account. However, the tax advantages of an IRA are astronomically better than a 401(k) and something you should absolutely be taking advantage of. A 401(k) allows you to contribute your PRE-tax income toward your retirement investments, whereas to contribute to an IRA, you use your POST-tax earnings. When it comes time to needing this money down the road, your withdrawals from your 401(k) are taxed. Making up for all of the years of pre-tax investing. On the other hand, your IRA withdrawals are completely tax free. The reason this is so great?
Let's say, when you were a fresh 22-year old joining the workforce, your chosen 401(k) plan purchased the next Amazon, Google or Apple. For a crazy small price of $10 because they hadn't yet exploded. Fast forward 40+ years when you are ready to retire and withdraw your hard-earned money from your 401(k), you will be taxed on the present day value of the company - which, if anything like Amazon, would by then be worth exponentially more. You wouldn't realize the earnings of this incredible investment.
On the other hand, if you had purchased “Amazon 2.0” through your IRA using your POST-tax money, you would get to walk away with the present day value of the stock, tax free.
Which option do you think would make you richer?
Before you get bogged down by the idea of picking stocks, remember that you don't actually have to do any of this work yourself. IRA's, just like 401(k)’s, are managed by brokers, or robo-brokers, that do all of this work for you. And, unless you're the next Warren Buffet, probably do a way better job.
One thing to note - IRA's do have an annual contribution limit and income restrictions. As of 2018, to contribute to a Roth IRA, you must have a gross income of less than $135,000 and the maximum that you can contribute each year is $5,500. So, the secret formula to retirement success is:
1) Contribute enough to your 401(k) to meet your employer match. Because, hey, free money!
2) If your budget allows, open an IRA and contribute as much as possible until you hit the $5,550 cap. All the while continuing to contribute enough to your 401(K) to meet your employer match.
3) If you still have money to burn and have already maxed out your IRA contributions, return to your 401(k) and increase your contributions as much as your budget allows.
*Note, you should NOT move on to Steps 2 and 3 if you have existing debt, other than student loan or mortgage debt. You will never earn enough of a return from your investments to outweigh the costs of your debt. Use any extra money to pay down these debts as quickly as possible.
To help you get started, here a few IRA accounts that I love and recommend for young people.
Wealthfront - This is the brokerage that I use for my IRA. Entirely online. It is also the brokerage where I have my primary investment account, so makes it easy for me to manage all of my investments in one place.
Know that if you’re even contributing to retirement at all, you are already doing SO much better than the average 20-something out there! However, we want to encourage you to take the next step. We know that you aren’t average and we want you to be able to live an above-average lifestyle! Comment below with any questions that you have about the power of an IRA or how to get started!