Please see the disclaimer in the 'About Me' section before proceeding...While it is not my area of professional practice, or perhaps my place to do so, I have undertaken the goal of trying to enlighten my friends as to the benefits of the Roth IRA this year. The Roth IRA was first explained to me in my undergraduate tax class 5 years ago, and ever since, I have been on the bandwagon saying how great these accounts are. A friend of mine asked me for some financial advice last week, and I put together a spreadsheet detailing why a Roth IRA at this stage in our lives (we are both 25, going on 26) is far more beneficial than contributing to a 401k. While I have believed this for many years, I had never put the numbers to the test, so here is quick and dirty version of what I came up with (sorry for the formatting, I am new at this):
Roth IRAIRA Contribution Limit $5,000
Bi Monthly Gross Pay 2,083 (Assume $50,000 salary)
Tax Paid 521 (Assume no pre-tax deductions, 25% tax bracket)
Paycheck 1,562
Bi-Monthly IRA Contribution 208
Take Home Pay 1,354
Historical Market Return 8% (Historical market return, +/-, with dividends re-invested)
Number of Periods 420 (12 months * 35 years)
Amount at Retirement 930,511
Gross Yearly Distribution 37,220 (Assume: retire at 60, and take 25 equal payments)
Net Distribution 37,220 (No tax paid on Roth IRA distributions)
401k (No Employer Match)401k Contribution Limit $5,000 (To match Roth IRA example)
Bi Monthly Gross Pay 2,083
Bi-Monthly 401k Contribution 208 (Pre-tax)
Tax Paid 469
Net Pay 1,406
Historical Market Return 8%
Average Fund Mgmt Fees 1.2%
Rate of Return 6.8% (Assuming the average mutual fund fee is 1.2% +/-)
Number of Periods 420
Amount at Retirement 706,754
Gross Yearly Distribution 28,270 (Retire at 60, 25 payments)
Tax paid 4,241 (15% income tax at this level on 401k distributions)
Net Distribution 24,030 (After tax)
401k (50% Employer Match) 401k Contribution (indiv) $5,000 (To match Roth IRA example)
401k Contribution (empl) 2,500
Bi Monthly Gross Pay 2,083
Bi-Monthly 401k Contribution 208 (Pre-tax)
Tax Paid 469
Net Pay 1,406
Historical Market Return 8%
Average Fund Mgmt Fees 1.2%
Rate of Return 6.8% (Assuming the average mutual fund fee is 1.2% +/-)
Number of Periods 420
Amount at Retirement 1,060,131
Gross Yearly Distribution 42,405 (Retire at 60, 25 payments)
Tax paid 10,601 (25% income tax at this level on 401k distributions)
Net Distribution 31,804 (After tax)
Now, before people get all up in arms, please realize that this example is for illustration purposes only, and is a very quick and dirty calculation. To check my math on the returns, you can go to any Future Value (FV) of an annuity calculator, and punch the numbers in yourself.
A few key points:
1) Under this example, there is no calculation for the return on the extra $52 per paycheck that you would take home contributing to the 401k. That will certainly close the gap between the rates of returns.
2) This calculation does not take into account commission fees realized in an IRA account. Assuming $10 per trade (seems to be the average these days), if you make 10 trades in the first few years, that's a sizeable portion of your account balance ($100 ($10x10) divided by $5,000 = 2%, which is more than the management fees on the 401k. However, with time, that amount drops to an insignificant level as you make contributions to your IRA. The management fee on a mutual fund, however, stays constant as a percentage of your balance. Therefore, that 2% shrinks in an IRA, while the 1.2% stays the same in a 401k.
3) This assumes that you invest in the QQQ (the ETF that tracks the DOW, and that the performance of the QQQ exactly mirrored the market, and that the market returned 8%) in your IRA, and that the funds in your 401k match the market. Obviously, your accounts will not achieve exactly those results. In my opinion, the IRA allows you to be more nimble, and offers a wider range of investment choices. As such, it becomes much easier in an IRA account, if you're a wise investor, to beat the market consistently.
Not to mention, did you know you can buy investment real estate in your IRA? Can't do that in a 401k.4) These assumptions basically only work until you take your first distribution at age 60. You'll notice, the rate of return and account balances are not adjusted for the years which follow the initial distribution. However, if I was a better man, and I am, I would bet that the calculation would favor the IRA if it was carried out until the account balance reached $0.
In asking around, fewer and fewer employers are offering company matches these days, and if they are, they seem to be shrinking. I remember about 15 years ago my dad told me he got a dollar for dollar match. Good luck finding that benefit these days. The company that I currently work for doesn't even offer a match (full disclosure, they make up for it elsewhere). I am guessing that as time goes by, fewer and fewer employers are going to offer that match, as the cost of employee benefits seems like it will be on the rise.
I encourage people to interact with this blog. Please leave comments or send personal e-mail, it is greatly appreciated when I hear other's views. If you would like to refute my calculations, I certainly would like to hear those arguments as well, and if you'd like, I will post them in this space.
