How to Build a Multi-Million Dollar Retirement Nest Egg with your Roth 401(k) plan
AI's response in regular print | Beverly Hills, CFP®, Joe O'Boyle's in italics
“How to Build a Multi-Million Dollar Retirement Nest Egg with your Roth 401(k) plan.”
You may contribute up to a maximum of $22,500 to your Roth 401(k) plan via payroll deductions during the 2023 calendar year. You may contribute up to $30,000 to your Roth 401(k) plan if you are age 50 or older in 2023.
When it comes to retirement planning, financial advisors often recommend leveraging time, compound returns, employer matching contributions, and your Roth 401(k) plan. These 4 components, when combined effectively, can substantially grow your retirement savings in a tax advantaged manner:
1. The Magic of Time
The first element, time, is arguably the most powerful resource available when saving for retirement. Starting early allows for a longer period for your contributions to grow. It's never too early to start, and even small amounts can grow significantly over time.
Consider two employees: Employee A begins contributing to their Roth 401(k) at 25, while Employee B waits until they're 45 to start saving. They both contribute the same amount each month, but when they both reach retirement at 65, Employee A has a significantly larger nest egg. This difference is attributable to the power of time.
Employee A starts contributing $550 per month to their Roth 401(k) at age 25, totaling $6,600 per year, and continues this till the age of 65. Assuming an average annual return of 6%, Employee A will have approximately $1.02 million in their Roth 401(k) at the age of 65.
For comparison, Employee B, who starts contributing the same $550 monthly amount, but not until they are age 45, and also continues until the age of 65. With the same 6% rate of return, Employee B will have approximately $242,000 at the age of 65.
This example highlights the power of starting early and the impact of compound interest over time. Even though both employees contribute the same monthly amount, Employee A ends up with significantly more (nearly $800,000) due to the years of extra contributions and compound growth from starting early.
2. Compound Returns: Your Money Working for You
Compound returns, the second element, is the mechanism through which your contributions grow over time. Compound returns work by earning returns not only on your original investment (the principal) but also on the returns that your investment has already generated. Over time, this snowball effect can lead to exponential growth of your retirement savings, often referred to as "the miracle of compounding."
For instance, if you contribute the Roth 401(k) maximum of $22,500 each year from age 25 to age 65, you would be contributing for 40 years. The total amount of your own contributions (also known as your principal) made via payroll deductions would be $900,000.
$22,500 annual Roth 401(k) contributions x 40 years = $900,000
However, your Roth 401(k) balance at retirement wouldn't just be the amount you contributed. Thanks to the power of compound returns, your money grows over time. If you're earning an average annual return of 6%, your balance at age 65 wouldn't just be $900,000; it would be considerably more. For example, if you contribute $22,500 each year for 40 years with a 6% annual return, the total value of your Roth 401(k) at age 65 would be approximately $3.5 million.
Therefore, of the $3.5 million retirement nest egg, only $900,000 is money you actually contributed. The remaining $2.6 million is all growth from compound returns and the best part is your full $3.5 million is potentially completely tax-free because it’s in your Roth 401(k) plan. This example illustrates the significant impact of compounding and why it's often referred to as "earning interest on interest." It's one of the most powerful forces in finance and a critical component of successful long-term financial planning. The power of compounding magnifies your savings and highlights why starting early can have a profound impact on your retirement.
3. Employer Matching: Free Money for Your Future
The third key element, if your employer offers a matching contribution to your 401(k) plan, can significantly accelerate the growth of your retirement savings by meaningfully bolstering your annual investment returns. It's essentially free money that your employer contributes towards your retirement plan, on top of your own contributions.
While it's important to note that employer matching is often made to a traditional pre-tax 401(k), not an after-tax Roth 401(k), the overall boost it gives to your retirement savings can't be understated. Make sure to contribute at least enough to your Roth 401(k) to receive the full employer match, if available, otherwise you are leaving free money on the table.
Many company 401(k) plans offer a standard safe harbor employer match where the employer will contribute (“match”) up to 4% of your salary as an employer contribution into your 401(k) plan as long as you contribute at least 5% of your salary to your 401(k) or Roth 401(k) plan via employee payroll deductions.
4. Tax-Free Benefits of a Roth 401(k):
The fourth key element, the Roth 401(k), offers unique advantages that make it an attractive option for many employees. Contributions to a Roth 401(k) are made with after-tax dollars. While you don't receive a tax deduction for contributions as you would with a traditional pre-tax 401(k), the growth and withdrawals in retirement are tax-free in a Roth 401(k). This can be especially beneficial if you expect to be in a higher tax bracket when you retire or plan to leave a legacy to your children or grandchildren.
Using the above example, the $3.5 million you've accumulated by age 65 can be withdrawn completely tax-free if held in a Roth 401(k), making for a more predictable and stable retirement income. Using a 4% annual distribution rate as a guideline, a $3.5 million nest egg in your Roth 401(k) may potentially generate $140,000 per year in tax-free annual retirement income (4% of $3.5 million = $140,000).
Bringing It All Together
When time, compound returns, employer matching, and the benefits of a Roth 401(k) are combined, you have a powerful retirement investment strategy. Starting early and contributing consistently allows compound interest and employer matching to multiply your savings over time. Contributing to a Roth 401(k) ensures that your retirement savings grow and can be withdrawn tax-free.
Taking a proactive approach to retirement planning, understanding these principles, and taking full advantage of your Roth 401(k) can significantly increase your retirement savings over the long term. It could mean the difference between retiring with hundreds of thousands of dollars and retiring as a multi-millionaire with a tax-free nest egg.
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Joe O'Boyle is the founder and principal of O'Boyle Wealth Management, a full service financial planning and investment management firm, located in Beverly Hills, California. Joe O’Boyle was named to InvestmentNews 40 under 40 class of 2016, and has a catalog of financial planning and investing articles on Money.com & U.S. News. Disclosure information.