You know the system is complex when even the most knowledgeable people studying questions of saving and retirement make mistakes. I realized I had been making a big mistake recently when it comes to my retirement savings. Instead of getting upset about it, I prefer to share my mistake so that other super savers avoid the same mistake.

What is a Super Saver?

The key point to this advice is you have to fall in what I call the “super saver” category. These are people that save as much as a quarter to half of their income and invest it with an eye towards growing it long term. If you work a 9 to 5, one of the easiest ways to do this is through a 401(k) plan if you work for a private company. The cousin to this plan in government jobs and the non-profit sectors are 403(b) and 457 plans. These plans usually have similar fare in what they offer: index funds for the stock market, target date funds as well as bond funds. If you work for the government or a non-profit, use the terms 403(b) and 457 interchangeably with 401(k) here.

For people with a long term view towards investing who are funding their retirement, my advice for the basics when it comes to these accounts are to pick a target date fund or a broad index fund and don’t plan to sell for many many years. The reason being is that those who take the risk of the market, don’t try to buy and sell to time the market and contribute regularly, end up doing spectacularly better than those who chase the hot investment over a period of 20-30 years or more. The mean return to the S&P 500 over periods of 20 years or more is approximately 10% which beats out every other broad investment class available to most people. The key is to stick with your strategy and deploy discipline via regularly contributing.

Employers usually offer some incentives to saving. These include matching a portion of your contribution. If anything, I always advise people to contribute at least up to the match, if not you literally are giving away free money. The match is what your employer contributes free of charge, it’s an added perk to employment I think everyone who has the ability should take advantage of.

There is also an option of 2 kinds of accounts for most people. A traditional 401(k) and a Roth 401(k). The difference being that a traditional 401(k) deducts your contribution pretax from your paycheck while the Roth 401(k) makes after tax contributions. I will get into why this matters later in the post.

Finally, there is a cap on the individual contributions that a person can make in any year to their 401(k) account. This cap does not count the matching portion or any profit sharing that some employers drop into your retirement account. Here are the caps summarized:

• Individual Contributions – For 2020 and 2021, these are capped at $19,500. This is the cap on what you yourself put in, not matching or profit sharing from your company. Anyone age 50 and older can add $6,500 to this figure as “catch up” contributions.
• Employer and Employee Contributions – There is a cap on the total contributions that an employee and employer can make together which is $57,000 annually ($63,500 for catch up). This means your employer can put as much as $37,500 towards your retirement through matching or profit sharing. If your job gives you this much, I would like to apply there.

Where I Went Wrong

So when I speak of super savers when it comes to retirement savings, I am talking about those who save up to the maximum. It isn’t the majority of us, many of us prioritize other things and put a bit into retirement until we get older and realize it isn’t far off and try to plow a bunch of money into it in order to compensate. I like my money to work for me. I would rather live a little more humble young and not worry as I age, but that’s just me.

There is a specific reason one would prefer a traditional 401(k) over a Roth 401(k). A Roth 401(k), since it is constructed using post tax money, is never taxed again as long as you spend the proceeds after you are 59 1/2. Many people would think this is preferable. The reason being that it’s simple, once you put it in and leave it, you don’t have to worry about taxes ever again.

A traditional 401(k) however, will delay your taxes. You won’t pay them today on that $19,500 you have stashed away but you will pay them later on the way out when they are taxed as ordinary income.

So all things equal, the only difference between a Roth 401(k) and a traditional 401(k) is the tax rate you will face today and the tax rate you face in retirement. If you think taxes will fall or you will make a lower income when older, then you should choose the traditional 401(k). If you think you will still be a high earner and the government will deduct even more money from your account at an old age, then a Roth is the best.

My logic for contributing to a traditional 401(k) was that I will be a much higher earner currently as opposed to when I am retired. By then, hopefully my home will be paid off, kids out of college, can live in a cheaper location and generally lower my required expenses, which will lower my income needed to fund fun things like trips or hobbies. This logic led me to stash away my 401(k) contributions for many years pretax.

My logic was sound but was forgetting one crucial thing: the above is true if you are not investing up to the cap. If you are investing up to the cap, it completely changes the math for you.

Let me give you a simple example of why. If your contributions are pre-tax, this means the funds can grow pre-tax but the future funds will be discounted by the tax rate when you are retired. Lets say right now your tax rate is 30% and when you retire it’s 20%. Let’s say you contribute up to the maximum of $19,500. That means your future value will be your return net of that 20% tax rate. If we discount that back to today it makes your hypothetical post tax contribution $19,500 x (1 – 20%) = $15,600. However, the Roth contributions are never taxed again, so even if you pay the higher tax now, the post tax value today of contributing is $19,500 or 25% more than what you put away pre-tax.

The other way to look at it is to make the Roth contribution it’s taxable equivalent of today. That would make the discounted present value of the amounts taking into account taxes as $19,500 for the traditional 401(k) and $24,375 ($19,500 / 80%) for the Roth 401(k).

Below the cap the math changes and usually favors the traditional 401(k). Investing $15,600 via a Roth 401(k) means the current taxable equivalent amount is $19,500 at the 20% rate but $22,286 at the 30% rate so it’s better to take the deduction now and contribute to the traditional 401(k).

The Opportunity Cost

One of the more painful exercises in investing is to look back and see what you could have earned if you just took a different approach. This means either making a better informed decision or it could mean investing in the index rather than trying to beat the market.

I have had the experience of investments that returned 10x my initial investment but I had to combine those with the investments I made that lost money to get the real picture. The fact of the matter was that I could have just invested aggressively in the market and gotten a better return over the long term than taking a chance of finding that 10x investment and losing on 2 others I thought would pan out. In the short term, people can easily beat the market but long term is much more difficult which I eventually realized.

My miscalculation with my 401(k) and allocating it all to pre-tax over the years helped me a bit on my post tax income during those years, and I did invest a good portion of the difference. However, not allocating to a Roth 401(k) when I had excess funds to do so was a mistake. It has likely cost me hundreds of thousands of dollars in future retirement income. All I can do now is switch my allocation and be happy I caught it now rather than later in life.

There is one argument in favor of investing in the traditional 401(k) which says that you have to diversify account types because the government can easily tax one type of account more than the other. Even in this case, you could invest up to the max for a Roth 401(k) and then contribute $6,000 a year into a traditional IRA which doesn’t have any income limits. Either way you cut it, the Roth 401(k) is the way to go if you are a super saver investing up to the cap.

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