It’s never, never too early to start using retirement accounts to save money on taxes. In many ways, you’re already late.
Taking a step back, there are two kinds of retirement accounts, typically an Individual Retirement Account (“IRA”) with a maximum annual contribution of $5,500, and employer-sponsored 401(k) plans, with a maximum annual contribution of up to $18,000.
Each of these retirement accounts has two types, a Roth and a Traditional. In the Roth, you pay your taxes upfront to avoid taxes later. In a Traditional (aka Regular), you pay your taxes later when you cash out, but avoid paying taxes now. The differences are subtle, and we’ll try to explain in a future post.
For our purposes, let’s assume you pay your taxes now on your income as usual, and invest in a Roth IRA and/or 401(k) account.
Let’s take an extreme example to illustrate how much you can save in taxes relative to NOT investing in a Roth retirement account. Assumptions below are in red, while output is in blue.
(-100% Contribution Growth means no additional contribution after the initial $5,000)
In this example, if you invested $5,000 in a Roth retirement account, you would end up with a portfolio valued at $65k and generate $4,278 in annual income.
If you invested in a regular account and paid taxes every year, your retirement portfolio would only be worth $34k and generate $1,743 in annual income.
In a retirement account, starting at age 28 and retiring at age 65, your $5k would grow 13x, while in a regular taxable account, it would only grow 7x. NOT investing in a ROTH in this case cost you $31k in profits!
This one simple administrative trick can save you hundreds of thousands of dollars over the years. The difference is huge!
You can use this simple retirement calculator to run your own numbers.
For kicks, I’ve run some aggressive numbers where I can work super hard until age 35, and then sit back and choose any job I want as long as I don’t raid my retirement accounts.
That’s a lot of savings, and a lot of cents.
Do you set aside as much money as you can to your ROTH or regular IRAs and 401(k)s?