Difference Between a 401k and a Roth IRA

By this point, you’ve heard me rave about the benefits of investing in retirement. Perhaps you’ve been won over and are excited about  the idea of getting started, but you feel like you don’t know where to begin. You’re not alone. Let’s look first at the basics of how a 401k and a Roth IRA work in order to lay the groundwork for beginning your journey to investing. In a future post, we’ll go step-by-step through how to actually start a retirement account, but it’s important to have this understanding first.

There are two main types of retirement accounts that we’ll focus on: a 401k and an IRA (Individual Retirement Arrangement).

Before we look at why these are valuable, consider why you wouldn’t want to just open up a regular account and start investing money for retirement on your own without them. You can absolutely do this, but the problem is that you will pay loads of taxes on the money you put in. You’ll be paying income tax on the money when you earn it from your job via Income Tax. On top of that you’ll be taxed on all of the great earnings that your investments made when you withdraw money, which is known as Capital Gains tax. This is a huge amount of taxes and money down the drain for you.

You can think of a 401k or a Roth IRA like a bucket that you can put your investments in to shield them against taxes. The main difference between them is the point in life at which you choose to pay the taxes.

With a 401k, all of the contributions you make are tax-free,  meaning that if you contribute $10,000 to your 401k in a year, you don’t have to give Uncle Sam any of that money like you normally would when you get money in a paycheck. Essentially, the money gets filtered into your 401k before the government has a chance to grab any of it from you. If you were in the 25% tax bracket, this would save you $2,500 in taxes right off the bat. Also, you won’t have to pay taxes on any of the growth of that money (capital gains). The downside with the 401k, however, is that you will have to pay your taxes in retirement when you take the money out. If you’re rich in retirement and are “earning” more income by withdrawing from your investments than you were when you put the money into your account, you’ll be paying a higher percentage in taxes at that point.

With a Roth IRA, you pay your taxes up front and never have to worry about paying any taxes on your investments in the future.  So, if you had that same $10,000 to invest in a Roth IRA and were in the 25% tax bracket now, you would pay the $2,500 in taxes up front and the other $7,500 would go into your Roth IRA. These taxes just get taken out of your paycheck like they normally do with any paycheck. Then, you invest that money in your Roth IRA. This may seem like a worse option than the 401k at first glance, but when you look at the long-term effect of not having to pay taxes in retirement, it’s pretty awesome. The Roth IRA is generally best if you expect to be making more in retirement than you’re earning now from your career. The reason is that you can pay the lighter tax load now and your money can grow to enormous numbers without you having to worry about paying steep taxes later.

The general rule of thumb is that if you’re fairly young (under, say, 35) and early in your career, you probably want to put your money in a Roth IRA. This is because your income tax bracket is significantly lower than it likely will be after you’re retired.

For both the 401k and the Roth IRA, there are limits to how much you can put in each year. For a 401k, the limit is currently $17,500, while you can only put $5,500 into a Roth IRA each year. A good strategy that I personally use is to start out putting whatever percentage your company will match, if any, into a 401k. Then, put the rest into a Roth IRA to get yourself up to 15% altogether. If you hit the maximum on your Roth IRA in a year, then go ahead and start maxing out your 401k.

To put this into a practical example, assume you make $50,000 per year. 15% of your salary would be $7500. If your company matched 2%, you would put 2% of your salary each month into your 401k and 13% into your Roth IRA.  After about 10 months, you would reach the $5,500 maximum in your Roth IRA and would then contribute the full 15% to your 401k until the end of the year.

If you’re married, the contribution limits are on a per-individual basis. This means you and your spouse can each have your own accounts with $17,500 for your 401k and $5,500 for your Roth IRA. As a result, if you’re married, your limits are really $35,000 and $11,000. Not too shabby!

Hope this was helpful to you. These tax concepts can be pretty confusing at first, so as always, feel free to leave any questions you have in the comments and I’ll do my best to answer them.

Gradual Millionaire Retirement Exploration Tool

I’ve played around with a number of retirement calculators out there online, but I haven’t been completely satisfied with any of them. The main problem I’ve found with most is that they don’t offer much in the way of visualization. If they do have a graph, it’s usually just a bar chart or something that doesn’t provide an effective way of seeing how your money grows over time.

So, over the past couple of weeks, I decided to develop my own tool so I could play around with the numbers and visualize what small changes in contributions to retirement plans would amount to over the long run.

Feel free to head on over to the Gradual Millionaire Retirement Calculator to check it out!

When you go to the page, you’ll simply need to enter a few details about your situation. By the way, I have programmed the tool in such a way that all of the calculations are done in your browser, so I have no way of seeing your numbers even if I had any interest whatsoever in doing so.  All you have to do is enter:

  • Your current age
  • Your annual income
  • How much you already have stocked away in retirement accounts (if you don’t have any money invested yet, you can just enter zero here. We’ll cover how to start investing in your retirement in a future post).
  • Annual contribution percentage. This is the percentage of your salary you plan to contribute toward retirement. By default, this is set to 15 since that is generally a good rule of thumb, but it depends a lot on your age and your specific goals. If you’re on a tablet, you’ll have to press the point you want rather than sliding.
  • The age at which you want to retire. This is set to 65 as that’s the standard for Americans. I personally never plan to work anywhere close to that long, but feel free to put whatever number you like here just to see.
  • The interest rate at which you assume your investments will grow. Most investors say that somewhere between 7-10% is reasonable when investing over the long haul in mutual funds, so go ahead and see how your numbers change when you slide this percentage around. It’s amazing to see what a huge difference a percentage point makes over decades of compounding interest.

Last, but not least, go ahead and press “Calculate!”

A graph will magically appear on the page. You can slide your mouse over the graph to see how much money you’ll have in investments at any specific age you like. Tip: slide your mouse between two consecutive years in the later part of your life, such as in your late 50’s or your 60’s. It’s pretty awesome to see just how much money you’ll be raking in every year for doing absolutely nothing! This is why I think having an interactive visualization is powerful. You can more easily see the power of compound interest working in your favor! If you’re viewing the page on a tablet, you can see any point on the graph by simply pressing on the graph.

I hope this proves both fun and inspiring to you! Take advantage of the tool by seeing how much more you’ll have in retirement if you contribute a couple extra percent from your salary, if the interest you earn is a little higher or lower than average, or if you retired later/earlier.

Please let me know if you have any comments or suggestions on the tool that you think would make it even more useful. I’d also love to hear if there was anything surprising you found using it!


Car Insurance Simplified

I recently bought a car, and a few days after adding the “new” vehicle to my car insurance, I noticed Geico automatically tacked on a few unwanted charges.

The first thing I noticed was an added service for Rental Reimbursement at $21.12 PER CAR per 6 months. That’s $42.24 of our hard earned dollars spent every half-year just so that we can still continue to drive two cars for a few days on the off chance that one of us gets in an accident. And that’s only if the accident happened to be our fault. Sure, it would be convenient to have an extra set of wheels, but I think we can manage to work out some transportation for a few days in the event of a car repair or replacement. Ambrey could drop me off at the bus stop for work or we could find some other creative solutions. I’d much rather have $42 in my pocket for a dinner date or to put toward a downpayment on a house.

Now, I’m not dissing Geico. Last year I set aside a few hours to make phone calls to several car insurance companies and get quotes on the best prices for the coverage we needed. As it turns out, Geico, who we were already with, was cheaper than the rest by a long shot.

But, no matter who you choose, you need to take a close look at each piece of coverage you’re paying for in order to get the best value. You don’t want to be bankrupted by a car wreck, but at the same time, you certainly don’t want to be wasting precious money on coverage you don’t need. Plus, you may be able to score some discounts on the prices you’re already paying just for being a long-time customer, getting good grades, or having multiple policies with that provider. Let’s go through the basics step by step:

The first and most important coverage is “liability.” Liability is the amount of money that you’re responsible for paying if you cause damage to another person or vehicle with your vehicle.

The first type of liability is called “bodily injury liability.” Just as the name suggests, this insurance covers any costs associated with injury or death of others caused by you in an accident. It also pays for your legal defense. You really want this coverage to be much higher than whatever the legal minimum is. Just imagine if, God forbid, you happened to strike a pedestrian or got in a severe enough accident that you caused brain damage, paralysis, or even death of somebody else. These costs can really add up, and if your bodily injury liability coverage limits aren’t high enough, the injured party can sue you for your assets, potentially garnishing your wages, wiping out your retirement, and otherwise bankrupting you.

You will see two different limits associated with your bodily injury insurance. The first is the “per person” coverage. This is the maximum the insurance provider will cover per individual in an accident. The next number is the “per occurrence” coverage, which is the maximum your insurance will cover in a single accident. So, for example, let’s say you had $100,000 per person/$300,000 per occurrence coverage and you caused a collision with a minivan on the highway. Let’s assume there were 7 people in their van with significant injuries. The insurance company will cover up to $100,000 per person for injuries, but will cover no more than $300,000 altogether.

The other type of liability coverage is property damage. This one is pretty straightforward. This is the maximum that the insurance company will cover in damage to other vehicles or property. Keep in mind that you could cause an accident with an expensive new car or cause an accident that involves several vehicles, so this limit should also be considerably high.

The good news with liability insurance is that it really does not cost much more to bump up your limits, so it’s probably worth jacking those up substantially to protect your assets from lawsuits.

Now that we’ve covered insurance that covers the cost of damage to others, let’s look at coverage that protects you in the event of an accident.

Uninsured motorist coverage is absolutely essential and protects you against stupid drivers without insurance. Unfortunately, we all pay a cost to protect ourselves from people who choose to ignore the law and carelessly put others in danger. It’s entirely unfair, but it’s just the way it is. This insurance comes in the same forms as liability insurance (“bodily injury” and “property damage”), with “per person” and “per occurrence” limits just like liability. You may think you’re unlikely to be hit by an uninsured motorist, but they’re more common that you might imagine, particularly in low-income areas. Both my dad and brother have been the victims of hit-and-runs while driving in the city. Not cool!

There’s one item on my coverage that I admit I need to do some more research on, and that is Personal Injury Protection (PIP). According to Geico, PIP “pays for necessary medical, dental, hospital and funeral expenses, 85% loss of income and loss of services incurred within three years of a motor vehicle accident. PIP covers you, household relatives, passengers and pedestrians regardless of fault.” Considering that we have other types of insurance for these other expenses such as health, dental, and disability insurance, this seems unnecessary. I’m going to plan to do some more research on this and see if this is duplicate coverage that I could get waived for a reduction in cost. I’ll get back to you on this once I find out.

Collision insurance covers damage to your vehicle caused by hitting another vehicle or object. One thing to keep in mind here is that damage caused by hitting an animal is not covered under collision insurance. Where I live, deer are everywhere and it is definitely not unlikely that you could hit one and total your car. If you’re expecting your collision insurance to cover this, you’ll be out of luck.

Comprehensive insurance basically covers damage to your car caused by situations other than collisions, such as hitting a deer or other animal, theft, vandalism, flooding, hail, lightning, explosions, and a bunch of other cases.

If you drive an older car that’s not worth much anymore and you can afford to replace the car if you needed to, it is worth considering dropping the collision insurance coverage. The coverage may be costing you more than it’s worth. I didn’t carry collision on my old ’97 Jeep Grand Cherokee because it was only worth $1500 on Kelly Blue Book. It wasn’t worth the hundred or more dollars per month for collision coverage when it would be cheaper overall just to replace it if it was totaled. However, now that I have a newer, more expensive car, it is absolutely necessary and worth it for me to have collision and comprehensive to protect against several thousand dollars in damages.

Another way to save some money on your insurance is to raise the deductibles. The deductible is the amount that you owe out of pocket before the insurance will kick in to cover the rest. If you have a $250 deductible and you have $1,000 in damages from hitting a pole, you’ll be responsible for $250 and the insurance company will pay for the other $750. Raising your deductibles causes you to pay less in premiums. Premiums are simply the costs you pay each month for your coverage.

Be sure to look for any discounts that you can apply. If you’re a student, you can usually get discounts for good grades. If you have a good credit score, you’ll pay less. Get renter’s or homeowner’s insurance bundled with your car insurance and you’ll get a discount.

Lastly, opt to pay for your insurance every 6 months rather than on a monthly basis and you’ll save a nice chunk in administrative fees. For me, I can save about $30-$35 every 6 months by paying once. A great way to accomplish this is to set up an automatic transfer into your savings account each month for the amount you would be paying monthly for insurance. Then, when the 6 months are up and your insurance payment is due, you’ve already saved the amount you need plus interest, while avoiding the hefty fees on top of that.

Hope this was helpful to you! If you have any questions on any of this, let me know in the comments below and I’ll do my absolute best to answer them for you. Most importantly, I encourage you to take a few minutes to look through your coverage and find out what tweaks you need to make. Call around to different companies, as well, and you could save yourself a few hundred dollars. Good luck!