How to supercharge your 401k

In today's discussion, we are going to delve into the fundamental principles of investing, the comparison between 401K, IRA, and Roth accounts, as well as the importance of understanding and optimizing these accounts. We'll also explore the significance of rolling over old 401K accounts and the benefits that come with it.

To top it off, we will discuss how to effectively optimize your 401K by eliminating high-fee funds and replacing them with low-fee alternatives. Additionally, we will examine ways to maximize your employer contributions and highlight the necessity of rebalancing and resisting panic-driven decisions, which is admittedly challenging for all of us.

Now, let's delve into the principles of investing. The first rule to remember is that compounding is the king. We all, at some point or another, harbor dreams of getting rich quickly, only to realize that wealth accumulation doesn't happen overnight. As Albert Einstein once declared, compounding is the eighth wonder of the world. By investing early and continuously, you can harness the power of compounding to expedite your journey toward financial independence.

Next, we will look at the cost of funds and investing in trading. It's always in your best interest to keep costs low, and this can be achieved by choosing low-cost funds for your 401k portfolio. We will walk you through this process in the latter part of our discussion.

Taxes are a certainty in life; they support the upkeep of our nation, including the military. But, if there are legal ways to optimize your tax payments, it's certainly worth exploring, and we will show you a few ways to do that.

Keeping it simple is always a good strategy. Every account you create and each investment you make consumes your precious time. Hence, it's essential to keep things simple, focused, and scalable, allowing you to dedicate your time to what matters most.

Moreover, maintaining a steady course is essential. Market fluctuations, bank failures, and economic recessions are all part of the investment journey. What's important is to stay on track, keep investing, and periodically rebalance your portfolio.

Now, let's talk about compounding, a simple concept that's often hard to grasp due to its slow nature. It doesn't happen overnight, or even over a year—it takes a considerable amount of time. Let's say you start saving $22,500 annually, which is the annual limit for 401K set by the government, and invest this amount in a low-cost S&P 500 fund. By the 18th year, you would have a million dollars in your account, even though your actual contribution would be approximately $400,000. That's the magic of compounding.

If you continue at this pace, assuming the 401K contributions don't change, you could accumulate more than $3.5 million over the next 30 years. The power of compounding lies in allowing your money to grow over time, and the longer you let it compound, the better the results. After about seven or eight years, you will begin to see your compound growth surpassing your contributions. Thus, staying invested for the long term is crucial. By popular demand, we're going to tackle a topic many of you have expressed interest in the difference between 401K, Roth IRA, and other retirement accounts. When asked, many people believe the maximum they can contribute towards their retirement accounts pre-tax and post-tax is $22,500. However, the reality is that an individual can contribute up to $80,250 in tax-advantaged accounts for their retirement. This probably comes as a surprise, but let's break it down.

First and foremost, your priority should be to maximize your 401K contribution. For 2023, this amount is $22,500. The primary advantage here is that these contributions are tax-deductible. So, for example, if you're in the 30% tax bracket, a contribution of $22,000 could save you $5,500 in taxes.

Second, you should figure out how much your employer will match on your 401K contributions. Some of the highest-paying companies, particularly in areas like Silicon Valley, offer up to a 50% match. Companies like Facebook, Google, and Microsoft are known to do this. With a 50% employer match, your contribution can climb to $33,750.

Additionally, if your employer allows it, you can contribute up to $66,000, which is the federal maximum allowance for all 401K contributions. This amount includes both your contributions and your employer's. After accounting for these, any remaining portion can be put into a post-tax 401K. This is a strategy I've used for years, and it's a great way to add another $33,750 to your post-tax 401K. This brings the total to $66,000, the maximum federally allowed 401K contribution.

But there's more. Even if you have a 401K, the IRS still allows you to contribute $6,500 into a post-tax IRA account. If you're married, your spouse can contribute the same amount, even if they're not working. This adds another $13,000, but even for an individual, it's an extra $6,500. Now, you're up to a total of $72,500 in contributions.

Lastly, if your employer offers a Health Savings Account (HSA) and you have a high-deductible health insurance plan, you can opt for an HSA. You can contribute another $7,750 per household to your retirement account through your HSA. This brings the total to $80,250.

In conclusion, by following all the rules and regulations, and being proactive and informed, you can contribute up to $80,250 towards tax-advantaged accounts for your retirement.

In this next section, Prahlad is going to explain how you can convert post-tax 401K contributions into a Roth IRA.

Both post-tax 401K contributions and traditional IRA contributions are made with after-tax money, meaning you've already paid taxes on these funds. These can be rolled over into a Roth IRA, which offers a significant advantage: you won't owe taxes on the growth of these investments. If you left your money in a traditional IRA or post-tax 401K, you'd owe taxes on the earnings, but in a Roth IRA, all growth is tax-free. This tactic is commonly referred to as a backdoor IRA or mega backdoor IRA, depending on the amount you're rolling over.

However, it's important to note that this process does involve some paperwork. When you roll over funds, you'll receive a 1099-R form from your account custodian, which will need to be reported on your tax return. There's no additional tax to pay since you're rolling over, but the transaction becomes part of your tax records.

Now, let's talk about pre-tax vs. Roth 401K. Pre-tax 401K contributions are tax-deferred, meaning you don't pay taxes on the money today. Instead, you'll owe taxes when you withdraw the funds in retirement, with the withdrawals counted as regular income for that year. This is why it's termed "tax-deferred": you're deferring your tax obligations to a future date.

On the other hand, Roth 401K contributions are made with after-tax money. Whether you contribute directly to a Roth 401K or rollover funds from a pre-tax 401K or IRA, you've already paid taxes on the money. This means you won't owe any additional taxes on the growth of these funds, even when you make withdrawals in retirement.

Choosing between pre-tax and Roth contributions can be tricky. It often comes down to comparing your current tax bracket to what you expect your tax bracket to be in retirement. If you expect to be in a lower tax bracket in retirement, it may make more sense to defer your tax obligations with a pre-tax 401K. Conversely, if you expect to be in a higher tax bracket in retirement, you may benefit more from a Roth 401K, paying the taxes now to avoid higher taxes later.

However, predicting future income and tax brackets isn't an exact science. It can be beneficial to diversify by contributing to both pre-tax and Roth accounts. A mix of pre-tax and after-tax contributions can provide a hedge against future uncertainty, providing you with tax flexibility in retirement.

In the next section, we are going to explain the differences between post-tax and Roth contributions, and then he discusses the different types of investment accounts and their tax implications.

In terms of post-tax and Roth contributions, the primary difference lies in the income limits set by the government. For Roth contributions, there is an income limit beyond which you cannot contribute directly. However, post-tax 401K contributions don't have such income limits, assuming your employer allows post-tax contributions. While the government initially set the income limit for Roth contributions to assist lower-income earners, a tax loophole allows anyone to roll over funds from a 401K or IRA to a Roth IRA, essentially bypassing the income limit. This is known as a backdoor Roth IRA. There has been discussion in Congress about eliminating this loophole, but no action has been taken yet.

Prahlad then breaks down the differences between various types of investment accounts, namely:

1. Regular Brokerage Account: Money is contributed after taxes have been paid. Growth is taxed and if a dividend is received, it's taxed in the year it's accrued. There's no separate tax when selling assets; you only pay tax on the growth.

2. Tax-Deferred Account (like a 401K or traditional IRA): Contributions are not taxed because taxes are deferred. However, when you withdraw money in retirement, you will be taxed on both the growth and the original contributions.

3. Tax-Advantaged Account (like a Roth IRA): Contributions are made with after-tax money, so you've already paid taxes on these funds. The growth and withdrawals are never taxed.

4. Triple Tax-Advantaged Account (like an HSA): Contributions, growth, and withdrawals for qualified medical expenses are not taxed. However, some states like New Jersey and California do tax the contributions and growth. If you don't use the money for medical expenses, after a certain age, you can take distributions just like a 401K, but these will be taxed.

The key takeaway is that the type of account you choose can have significant tax implications, and it's important to consider these factors when planning for retirement.

In this part of the conversation, we are going to discuss the benefits of rolling over old 401(k) accounts and the choice between rolling into a new 401(k) or an IRA.

it's essential to roll over old 401(k) accounts when changing jobs. Leaving money in old 401(k) accounts can lead to lower returns due to the change in the management of the funds once an employee leaves a company. This can happen because the deals between employers and 401(k) providers like Schwab, Fidelity, or Prudential change when an employee leaves, potentially moving the funds into less advantageous positions.

Also, managing multiple accounts requires time and attention, which many busy professionals don't have. As a result, these old 401(k) accounts often get neglected, leading to suboptimal growth or even losses. Therefore, it's recommended to roll over old 401(k)s into a new account, either the 401(k) at a new employer or into an Individual Retirement Account (IRA).

The process of rolling over a 401(k) is simple. You need to contact your old 401(k) provider, instruct them to sell all the assets, and send the checks to your address. There won't be any tax issues as the money is moving from one tax-advantaged account to another. Once you receive the checks, you can deposit them into your new 401(k) or IRA.

As for choosing between a 401(k) and an IRA, we think 401(k)s are generally less stressful because they require fewer decisions. However, if you want more control over your investments, an IRA might be a better choice because you can invest in individual stocks and ETFs. Prahlad also points out that 401(k)s have bankruptcy protection, which is an additional advantage that IRAs do not offer.

In this part of the conversation, the speaker is discussing ways to improve 401k returns. He criticizes how investment options are presented in typical 401k accounts, asserting that investment firms often make the selection process unnecessarily complicated to benefit themselves. This complication can confuse individuals, making it difficult for them to make optimal investment decisions.

He uses an example to illustrate his point, comparing two different funds within a Fidelity 401k account. The first fund, a target-date fund, had returns of 8.6% over ten years and an expense ratio of 0.75%. The second fund, an index fund, had a significantly lower expense ratio and higher returns (12.95%).

The speaker points out that despite the second fund's better performance and lower fees, it is not necessarily promoted as the better option by the investment firm. This, he suggests, is because the investment firm stands to gain more from the higher fees associated with the first fund.

Xillion is a service that simplifies the investment decision-making process. Xillion provides clear comparisons between different funds, highlighting factors like returns and fees to help individuals make more informed choices.

The potential long-term impact of these decisions with a real customer example. By investing $30,000 properly over 30 years, the customer could see a substantial increase in their total savings, highlighting the importance of informed decision-making when it comes to 401k investments.

In this portion of the conversation, the speakers discuss various aspects of maximizing your 401k returns and investment strategies.

Maximizing Employer Contributions: The speakers emphasize the importance of taking advantage of any employer match on 401k contributions. This is essentially free money that not only increases your retirement savings but also grows due to compounding interest over time. However, they caution against front-loading your 401k contributions if your employer matches a specific percentage of your salary each month. In such cases, you should spread out your contributions throughout the year to maximize the employer match.

Rebalancing and Not Panicking: The speakers discuss the importance of staying invested and not panicking during market downturns. They suggest that if the market drops more than 10% in a month, it might be a good idea to invest more, as you're likely to come out better in the long run.

1. Employer Contributions for Moving Countries: The speakers advise that moving countries shouldn't impact your 401k investments. If you leave the U.S., your investments will still be waiting for you when you return. If you plan to settle in another country, there are no known disadvantages to keeping your 401k investments as they are. In fact, withdrawing your 401k prematurely can lead to penalties and tax obligations.

2. Management Fees: They strongly advise against paying a 1% management fee to bankers, arguing that most money managers can't beat the S&P 500 over a 15-year period. They recommend investing in broad market indices like the S&P 500 or in American growth companies for long-term growth.

3. Withdrawal Strategy: The speakers briefly touch on the topic of withdrawal strategy during retirement. The choice between taking lump sum withdrawals versus regular income can depend on factors like your tax situation at the time of retirement. They suggest that they are working on a tool to help with such decisions.