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This Strategy CRUSHES Roth IRA Investing

Free climbing without a safety line, hundreds of feet off the ground is impressive to see, but how well would you perform with nothing to catch you?

Fear of death makes focusing on your next move very difficult. You are more likely to succeed in putting yourself out there if you have a safety net.

We all know that you can only maximize your performance if you feel secure. The same is true if your goal is building wealth. Taking financial risk is so much more difficult if you do not have a safety net in position to catch you if at first, you fail.

In this article, I’m going to break down the cheapest way to build a financial safety net that will secure your retirement.

The fastest way to build wealth is by investing in yourself and taking some risks. Many people pass up opportunities in life because the risk feels too great. Unlock your full potential to go all in by knowing your long-term finances are settled. Whether that means starting a business or taking full advantage of that once-in-a-lifetime investment.

On the go? Watch this video instead:

Let’s get into it!

Hypothetical Build-out

Full disclosure, I use this strategy, but I will not be using my personal numbers. For the sake of this article, I will be using data for the median American, median salary, 401k, retirement age, social security benefit, etc…

So let’s build out my hypothetical situation so I can demonstrate how I use the safety net strategy.

1. Median Salary by Age

The median salary for Americans aged 25–34 is $52,936 but I will round up to $53K. My hypothetical age will be right in the middle of that age range — 30 years young.

Median salary by age

2. Average Employer Match for 401K

According to the US Bureau of Labor Statistics, 69% of private employers and 92% of government employers offer 401k so I will have access to a 401k.

At the end of the article, I will give some bonus content for an alternate strategy if you happen to not have access so don’t worry.

Percentage of Workers with 401K access

The average employer match is around 4.5% but I am actually going to break away from the data here a bit and use a more conservative figure.

Employer match just means that if you put a certain amount, in this case, 4.5% of your salary, into your 401k, your employer will match some or all of that deposit.

In my hypothetical situation, my employer will only match half of what I put in up to 6%. This means that if I put in 6% then my employer will put in 3%. 6% of my $53K salary is $3,180 and the 3% match is $1,590.

3. Average Retirement Age

According to this article by Investopedia, the average retirement age is about 64.

If I fail at all other wealth-building strategies throughout my life, I will have 34 years of work before I can retire on average and live comfortably on this safety net strategy as a last resort.

4. Average Social Security Benefit

The safety net strategy will also be supplemented by social security.

According to this article, the average social security benefit is $21,384 per year as of February 2023.

Inflation Explanation

Alright! We have built my hypothetical situation.

I should go ahead and mention that all calculations will be in today’s dollars. That means I will be accounting for inflation as I project out 34 years by reducing the return on my investments.

You would be surprised how much of a difference inflation makes over that time span. In fact, I will show you the difference in spending power as we make calculations throughout the article.

The average rate of inflation from 1960 to 2022 is 3.8% per year according to this article from WorldData.

My Situation, Maybe Yours Too

So here is the situation: I have an average job with an average salary but I want more. I want to put all of my extra time and money towards investing in myself by starting a business on the side.

However, starting a business is a risky endeavor, so of course I want the security of knowing that I will not doom myself to working until literal death. I want to know that I will be able to stop working and live comfortably in old age. Having security will let me go all in without fear.

So what is the most efficient strategy?

Time to do the math.

Why Should You Invest in a Traditional 401K?

The traditional 401k has three primary advantages.

It is a pre-tax investment.

You get an employer match to boost your returns.

It grows tax-free.

I will get into the numbers for all three of these benefits. Let’s start with pre-tax.

1. Pre-tax Investment

Mindmap by author explaining the benefit of traditional 401k as a pre-tax investment

With an annual income of $53k, I am in the 12% federal tax bracket and hypothetically live in a state that charges a 5% state income tax.

This means that if I get a $100 raise, my paycheck only increases by $83.

The same applies to deductions! If I put $100 in a 401k, my paycheck only drops by $83.

It’s like getting a 17% boost on your investment straight away. I get to invest $100 but it only costs me $83.

Mindmap by author explaining tax deferral benefit of traditional 401K

So if I invest 6% of my salary, that comes out to $3,180 but my yearly salary only reduces by $2,639.

Put into weekly terms, I am investing about $61 per week but my weekly paycheck is only reduced by about $51. Sacrificing $51 a week is very doable, especially since 401k is automatically deducted from your paycheck.

You don’t even have to think about investing it and you will grow accustomed to the slightly smaller weekly paycheck very fast.

2. Employer Match

Mindmap by author explaining how much to invest in traditional 401K to maximize employer match

The second benefit of the traditional 401k is the employer match.

This one is a no-brainer. I put in $3,180 and my employer put in $1,590. That makes for a total investment of $4,770 for the year even though your annual paycheck is only reduced by $2,639.

Once again, put into weekly terms, you are getting $51 less on your weekly paycheck but you are investing about $92.

To put that into perspective, the yearly return of the S&P 500 annualized over the last 50 years is about 10.8%. That means you’d have to be invested in the S&P for 6 or 7 years before you saw an 80.7% return. That’s pretty good.

3. Tax-free Growth

The final benefit of investing in a traditional 401k is that it grows tax-free. That means any dividends you receive will not be taxed and selling shares to rebalance will not be taxed.

This benefit is a little more complicated to calculate so I am gonna leave it out. Just know, there is another benefit on top of everything else.

What Does This Mean for You?

I feel like I can hear you screaming into your computer right about now. “What does it all mean???” Well, we are nearly there.

Now that I know how much I will be investing every year, I need to determine a reasonable estimate for my investment returns over a 34-year period.

401k options are typically limited but most will offer an S&P 500 index fund which is my personal investment of choice.

Calculating the historic return over 34 years of the S&P 500 (before inflation adjustment)

I will use dqydj.com which has a very handy calculator for average annualized returns over different investment durations for the S&P 500.

In this case, if you look at all the 34-year time periods in the history of the S&P 500, the average annualized return is 9.472%. Using past performance does not guarantee future returns but it’s the best I can do.

401K Investment Calculator (before inflation adjustment)

I will use this figure as an estimate for our future returns.

With this estimate, investing $4,770 in the S&P 500, (even though it only costs me $2,639) will be worth just over $103,000 after 34 years.

I must say, going from $2,639 to $103K is pretty solid.

Calculating the historic return over 34 years of the S&P 500 (after inflation adjustment)

… but now we have to account for inflation.

401K Investment Calculator (after inflation adjustment)

If we assume inflation will continue at an average rate, our initial investment will be worth $42,052 in today’s dollars. That is a pretty big hit but still pretty damn good.

So in this scenario, the small amount that I set aside when I was 30 gives me $42K to spend when I am 64.

But that’s not all, the average Social Security check adds another $21,384 per year in today’s dollars. I do not need to adjust social security for inflation because it increases every year proportionally to the cost of living.

That means in my 64th year I have $63,436 in today’s dollars to spend which is even more than my yearly salary when I was working at age 30.

With this safety net strategy, I create 34 years of income lasting from the age of 64 until I am 98 years old. Considering the average life expectancy in the US is just 76, this is a pretty good safety net.

What Should You Do?

Knowing this is my worst-case scenario if my other investments and ventures fail, I can feel free to really go for it and to take some risks with my remaining resources. I can take a real shot at building real wealth while I am young.

What If You Don’t Have Access to Traditional 401K?

And now for the BONUS content that I promised earlier in the article.

If I happened to be one of the unlucky few who does not get an employer match, then the next best thing is investing in a traditional IRA.

The traditional IRA is very similar to the traditional 401k. The only difference that matters for the purposes of this article is that the IRA is not linked to your employer in any way.

At the time of this article, you can open a traditional IRA with Robinhood and get a 1% match. This is much worse than a typical employer match but hey it’s better than nothing!

So if we invest the same $61 per week as we did in the above example, our paycheck will only be reduced by $51.

IRA Investment Calculator (after inflation adjustment)

But instead of ending up with a total investment for the year of $4,770, we only get about $3,212 because of the inferior match.

If we apply the same assumptions and calculations as before, we end up with about $28,315 after adjusting for inflation.

Finally, after adding the average annual social security benefit we have a yearly budget of about $49,700.

Still a pretty good yearly budget, but it is wild to see that the match alone cost us $13,737 per year for 34 years! That’s just over $467,000!

I think that is a great way to illustrate the power of the 401k match. To achieve the same $63,436 per year, your weekly paycheck would have to drop by about $75 instead of $51.

So it’s easy to see why I prefer the traditional 401k with employer match as the most efficient way to build your financial safety net, but this is a decent second-place option.

If you enjoyed this newsletter and would like to learn more about annualized returns versus average returns, there is a difference, check out Average Metrics Are Lying to You. Until next time!

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