How to invest your savings from your first paycheck?

July 4, 2020 Kaushal Building Wealth, Financial Independence

One of the best places to invest your savings from your first paycheck is the retirement accounts: a 401(k) and Roth IRA. Why? Because investing $10,000 per year in your retirement accounts starting in your 20s will make you a millionaire in your 60s!

What are 401(k) and Roth IRA?

They are retirement savings accounts. A 401(k) is an employer sponsored retirement plan and is generally included in the benefit package of eligible employees. On the other hand, a Roth IRA is an individual (self-directed) retirement account and is not associated with an employer benefit package.

Although 401(k) is more common, other retirement accounts such as 403(b) (public schools and tax-exempt organizations), 457 (state and local governments), and Thrift Savings Plan (TSP) (federal employees) have similar contribution limits and offer similar benefits to a 401(k) account.

401(k) vs. Roth IRA – Retirement Account Overview

Below is the brief overview of 401k and Roth IRA. (You can get more information from IRS.gov or other publications if you are interested in details)

401(k)	Roth IRA
Maximum contribution in 2020 $19,500 (under 50) $26,000 (50 and above)	Maximum contribution in 2020 $6,000 (under 50) $7,000 (50 and above)
Pre-tax (tax deductible)	After-tax
Employer match possibility, “free money”	No employer match
Tax deferred growth – subject to RMD (required minimum distribution)	Tax Free growth – Not subject to RMD
Penalty free withdrawal starting at 59 1/2	Withdraw principal at any time Withdraw any amount including growth at 59 1/2
No income limit to participate in 401(k)	Income limit to participate in Roth IRA

Invest your savings from your first paycheck in a 401(k) or Roth IRA?

So what is your plan? Invest in a 401(k) or Roth IRA or both? It all depends on the following question.

Does your employer offer a matching contribution in a 401(k) account?

If yes, that is great, get that “free money” by contributing to your 401(k) account up to the matching limit of the employer. The “free money” does not count towards the 401(k) contribution limit. If you still have money to invest, fund the Roth IRA up to the maximum limit.

If your employer does not offer a matching contribution in a 401(k) account, that sucks because there will be no “free money”. However, it is still a good idea to invest in a 401(k) account to take advantage of the tax deferred growth of your money. But, you fund your Roth IRA to the maximum contribution limit first, and then invest the rest to your 401(k) account.

Why fund a Roth IRA first when there is no 401(k) match?

Why should you fund a Roth IRA first if there is no 401(k) matching offered by the employer? In Roth IRA, you pay tax on the contribution at the beginning but your contribution and earnings grow tax free. After age 59 ½, all the money in a Roth IRA is yours, tax-free! In addition, there is no mandatory distribution such as Required Minimum Distribution (RMD). So your investment continues to grow tax-free until you decide to take money out of your Roth IRA account!

In contrast, 401(k) is subject to mandatory withdrawal such as RMD, generally starting at age 70 ½. The withdrawals are subject to federal, state, and local taxes. Remember, you did not pay taxes on the money you contributed as well as on the growth in your 401(k). Well, now Uncle Sam wants to collect the taxes you have been avoiding for decades. There is a hefty penalty if you do not withdraw the correct amount of RMD from 401(k), 50% for every dollar not withdrawn!

What about taxes?

Are you going to be in a higher tax bracket than today after decades from now? It depends on the individual situation and government tax policy. Some experts believe that tax increases in future may be necessary to reduce the deficit while the others believe that the government may start imposing taxes on Roth IRA accounts in the future! Yikes!

There is no way to predict future tax rates. But if you are in your 20s, just started investing, your income and tax rate are likely to increase in the future. Therefore, paying tax now while you are in the lower tax bracket and investing your after-tax dollars in a Roth IRA makes sense, particularly, when there is no 401(k) matching!

Let’s look at the numbers.

Let’s call upon our young professional, Jo. Jo is a recent college graduate starting a new job with a $50,000 annual salary. Her goal is to save 20% of her salary, which is $10,000. In addition, Jo’s employer is generous and matches 100% of her contribution up to 6% of her salary. How should Jo split her savings between a 401(k) and Roth IRA?

Remember the most important question to decide between 401(k) or Roth IRA! Does your employer offer a matching contribution in a 401(k) account? In Jo’s case, the answer is yes. So, Jo should start with 401(k) and fund up to the employer’s contribution amount, then fund the Roth IRA to the maximum contribution and invest the leftover money back into 401(k). Here is what it would look like:

401(k) contribution = $4,000 ($3,000 up to the employer’s matching contribution + $1,000 balance, left over after Roth IRA contribution)

Roth IRA contribution = $6,000 (maximum allowed in 2020)

Employer matching contribution to 401(k) = $3,000 (100% match up to 6% of salary)

Total Investment Amount = $13,000

Let’s say Jo starts to invest her savings in her early 20s, from her first paycheck. What would be the value of her 401(k) and Roth IRA accounts after 40 years (assuming she is increasing the contribution at average inflation of 2% and her investment grows at an annualized rate of return of 6%).

	Principal Amount	Compounding	Value of Investment
401(k) Contribution – Jo’s	$241,608	$641,626	$856,234
401(k) Contribution – Employer Match	$181,206	$460,969	$642,175
Roth IRA – Jo’s	$362,412	$921,939	$1,284,351
Total	$785,226	$1,997,534	$2,782,760

Almost $2.8 million dollars!

Yes, Jo’s total investment amount would be a whopping $2.78 million dollars after 40 years, of which almost 70% is due to the effect of compounding! The beauty of it all is that she may not have to pay any taxes on $1.28 million dollars in Roth IRA at all during her lifetime and possibly her beneficiary’s lifetime if she does not withdraw until the retirement age.

And, there is a possibility of saving tax on top of all this!

We have not even talked about how a contribution to 401(k) reduces Jo’s adjustable gross income (AGI) so she pays less in taxes. This could be another few thousands dollars that could be invested over 40 years.

In summary, consider starting to invest your savings from your first paycheck into appropriate retirement accounts and invest consistently.

Read more about investing via 401(k) and Roth IRA in this post. I also recommend reading the Risk Tolerance post to determine how much risk you are willing to take with your investment.

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