This episode is going to be a bit different from my usual videos.
1. This is going to be in English. Apologies to Tamil viewers. 2. This is targeted
towards US residents. If you are a non-us resident please feel free to save
yourself some time. 3. This is going to be presented by me. Not my dad. why you ask?
Because I can do a better job presenting in English than my dad can.
One of the problems that we face as the first generation of immigrants to the
USA is that we don't know much about the retirement plans available to us here.
By the time we come to know and learn about it, most of our working life would have
already passed. So in this newest retirement planning series, we're gonna
go more into detail about 401k and IRA and also why everyone, including
temporary visa holders, should participate in 401k & IRA.
But be warned there's math involved
Let's start by taking a look at the different tax brackets we have here in
the USA, as it is key to understand the benefits of retirement plans.
What you are seeing here is the current tax bracket. Let's say that our income is
100,000. That means that we are in the 24 percent tax bracket. That does not mean
that all our income of 100k is taxed at 24 percent. But it is taxed in different
brackets. Out of 100k. $9,700 is taxed at 10%. The amount between nine thousand
seven hundred and thirty nine thousand four hundred seventy five is
taxed at twelve percent and so on. So only fifteen thousand eight hundred
dollars is taxed at twenty four percent out of 100k. What this means is when we
save in a tax advantage account like 401k or IRA, the money we are
contributing is taken from the top tax bracket. In this 100k earnings example, if
we have contributed fifteen thousand eight hundred to 401k that would have
come from the twenty four percent tax bracket. Knowing this, let's get into
details about 401K. What is 401K? In simple terms, it is a tax advantage
account provided by employers that encourages employees to save for their
retirement. So what tax advantages are we getting by
contributing to 401K? Tax is deferred. what that means is, for the money that is
contributed, we will not be paying both federal and state tax now. But we will be
paying the tax, when we take the money out after retirement both on
contribution and earnings. If I'm going to pay the tax anyways, what is the
advantage? you ask. There are two big advantages. 1. You pay tax from bottom
up on tax bracket when we withdraw the money after retirement. Not on the
highest tax bracket. 2. We are reaping in the rewards from the growth of the
tax deferred amount rather than paying it immediately to IRS. To understand this
better, let's use our example of 100k earnings and 15800 contribution to 401K.
The whole 15,800 would have saved us 24% from federal tax and whatever
percent of our local state tax. In Illinois, it is 4.95 percent. So we
would have saved a total of 28.95% on tax during the time
of contribution. Let's say that we are retiring in 25 years. Let's also say that
we are contributing this $15,800 every year for
25 years. For a growth rate of 10%, this would result in a sum
close to 1.9 million after 25 years. What if we had not contributed to 401K, but
instead invested the equivalent money in a brokerage? After 24% in
federal tax and 4.9% in Illinois state tax we would
have contributed $11,226 into our
brokerage account instead of the $15,800 in 401K. As this
brokerage account is a taxable account the long-term capital gains are taxed at
15%. So that would result in an effective
annual return of 8.5% in brokerage account, compared to the 10% in
401K. By the end of 25 years, we would have $1.04 million
in the brokerage account compared to $1.9 million in the 401k account.
But the $1.04 million in the brokerage account has already
accounted for the long-term capital gain of 15%. So let's assume
there's no tax for withdrawal. But for 401K, we have to pay the taxes on the
amount that we are withdrawing. So how can we compare the balance in a
tax-advantaged account to a taxable account? The way that we can do the
comparison is by checking how long the money would last if we are withdrawing a
specific amount every month after retirement. So let's say that we need
$14,000 every month after retirement. That would put us in the
24% tax bracket. Let's see how long each account would last if
we withdraw $14,000 every month. Remember the balance would
continue to grow every year as we withdraw every month. The 1.9 million in
401K after paying tax every year would have lasted 25 years. But the
$1.04 million would have lasted for only ten years. That big difference is
coming from the growth of the tax deferral working to our advantage rather
than paying it to IRS every year. All the calculators used
for this calculation is in the description. You can check your own
scenarios with different numbers to understand this better. Now this by
itself is a huge benefit. But in addition to this, many employers match employees
contribution up to a certain percent. It is a no-brainer to take advantage of
that as it is a 100% return right there. As of 2020, the maximum contribution an
employee can make is$19,500 and if you are above 50
IRS allows an additional catch-up contribution of $6,500.
This dos not include employer match. For a 100k salaried person, maxing
out 401k is achieving 20% savings rate. As we saw in financial
freedom video, that is a great savings rate that can help us achieve our
freedom soon. There is another flavor of 401k that many employers have started
offering nowadays. It is called Roth 401k. In Roth 401k, we contribute the money
post tax. That is, after paying tax. But the contributed money grows tax-free. After
retirement we would be able to withdraw from Roth accounts without paying any
tax - both for contributions and also for earnings. In essence, it is the same as a
brokerage account. But with no tax on earnings. So what should we choose?
A regular 401k or Roth 401k? The answer is, it depends on the expected tax rate after
retirement. If our tax rate after retirement is going to be higher than we
are right now then it makes sense to contribute in Roth 401k. Only a small
% of us would be in that situation. Most of us will be in a lower tax
bracket. So for vast majority of us, it makes
sense to opt for regular 401k. Let's do some quick math to see why regular 401k
is better than Roth 401k in most cases. Let's go back to the same example of
100k income. If we contribute $15,800 to a regular 401k,
we are saving on a federal tax rate of 24% plus any state taxes.
If you choose to contribute to Roth 401k, we would have contributed
$11,226 every year, same as in the brokerage account
after paying taxes. But Roth 401k does not have any
capital gains tax like in a brokerage account. So we would have had
$1.34 million after twenty five years for a ten percent return rate. This
would have lasted for sixteen years for a $14,000 monthly withdrawal
as it does not have any tax for withdrawal. Equivalent money in regular 401k would
have lasted 25 years. So it is clear that for a 24% tax
rate and for a monthly withdrawal of $14,000, regular 401 K comes out way ahead
of Roth 401k. But Roth 401k is definitely better than a brokerage account where
the balance would have only lasted ten years. As a rule of thumb, if the marginal
tax rate is above 10%, it's better to contribute in regular 401k
than in a Roth 401k. Now when would we be able to withdraw the money? We can start
withdrawing the money after 59 1/2 years. Any withdrawal before
59 1/2, would result in a ten percent penalty.
The penalty is to discourage us from withdrawing from our retirement savings.
One of the biggest drawbacks with 401k is that it only has a selected list of
funds that we can invest in. That list is at our employers discretion. In
recent times, we are seeing many index fund options provided by the employer.
Based on your risk profile, choose the right index fund for you. Generally
recommended allocation is your age percent in bond index funds and
100 - your age % in stock index funds. Depending on your risk profile you can adjust the
% to your needs. Many H-1b visa holders assume that it is
not worth for them to contribute to 401k. The reasoning for them is that if we are
going back to our home country, why bother contributing to 401k. But as
we saw in the example above, even if we contribute for a few years, it is still
worth more than the money invested in brokerage. The only difference here is we
have to wait to retirement to access the funds. We will totally be able to access
the funds wherever we are after retirement. We just have to manage this
account like a bank account. Another advantage is that we get access to
invest in US Dollars and US assets directly. It's not always this
easy to get access to investing in US assets from foreign countries. There is
also another cool strategy that we can use when we move back to our home
country to access the 401k funds sooner than retirement. We will be covering that
in the part 2 of this series. What should we do if we're leaving the job? As we saw
before the 401k account is tied with the employer. When we leave the job, though
they will give us the option to continue holding our assets there, we should
actually be moving that money into an IRA. Regular 401k assets should be moved
into a traditional IRA and Roth 401k should be moved into Roth IRA. Why? To
understand that, we have to take a closer look at IRA accounts. We will be
covering IRA, Roth IRA and some other retirement strategies that we can use to
our advantage in part two of this series. If you liked the content of this channel,
please subscribe. We will soon meet again in part two of this series. Thank You.