You’ve no doubt heard the expression, “There’s more than one way to skin a cat.” Aside from the macabre implication of the adage, the point that there are usually multiple ways to accomplish a given task is true.
Americans have plenty of ways to save for retirement. Individual retirement accounts (IRAs) are widely used, and health savings accounts (HSAs) have gained popularity. But there’s another type of account that’s my favorite for building a millionaire retirement.
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My favorite retirement account
I contribute to several types of retirement accounts. For example, I max out my Roth IRA each year. If I could only use one retirement account, though, it would be the Roth 401(k) plan.
401(k) plans were first established with the passage of the Revenue Act of 1978. Section 401(k) of this legislation allowed employees to receive part of their income as tax-sheltered deferred compensation.
Under traditional 401(k) plans, you don’t pay income taxes on any contributions. Instead, the taxes on the contributions and any gains in the account must be paid when you begin to withdraw the money.
In 2001, though, the U.S. Congress passed the Economic Growth and Tax Relief Reconciliation Act. This bill paved the way for the introduction of Roth 401(k) plans in 2006.
Unlike traditional 401(k) plans, taxes must be paid on contributions to Roth accounts. However, the account then grows tax-free. Withdrawals can be made beginning at age 59 1/2 (as long as the account is at least five years old).
Why Roth 401(k) plans are so attractive
This tax-free growth is arguably the best attribute of Roth 401(k) plans. You’ll ultimately have to pay taxes on contributions with any type of 401(k) account. However, no taxes will have to be paid on the gains generated in a Roth account. Over time, those gains could be much bigger than the contributions.
The massive U.S. debt could lead to tax increases down the road. Roth 401(k) plans provide a way to partially hedge against this possibility.
With traditional 401(k) plans, you have to begin taking required minimum distributions (RMDs) once you reach age 72. There are no RMDs with Roth 401(k) plans beginning in 2024.
IRAs limit you to contributing a maximum of $7,000 per year (or $8,000 if you’re age 50 or over). HSAs limit individuals to contributing $4,150 or $8,300 for family coverage (although once you reach age 55, you can contribute an additional $1,000.) Roth and traditional 401(k) plans have a much higher employer contribution limit of $23,000.
Your employer can also match your contributions with 401(k) accounts. This amounts to free money that can greatly increase your retirement savings. If you’re self-employed, you can make contributions as both employee and employer.
HSAs also support employer contributions, but the limits mentioned above still apply. This means if your employer contributes $1,000, you’ll only be able to contribute $3,150 as an individual.
Can a Roth 401(k) really help you retire as a millionaire?
Whether or not you retire as a millionaire using a Roth 401(k) plan depends on the amounts contributed, the length of time your money grows, and the rate of return you obtain. However, building a retirement account of at least $1 million is quite attainable for many people.
Let’s assume the following:
- You contribute $1,000 per month into a Roth 401(k) plan throughout a 35-year career.
- You achieve an average annual return of 7%.
At the end of the 35 years, your Roth 401(k) account would have grown to more than $1.8 million. And that doesn’t include the impact of any employer matches.
One downside
One downside of Roth 401(k) plans is that not every employer offers them. However, there’s encouraging news on this front. A little over 89% of employers with 401(k) plans now give employees a Roth option, according to the Plan Sponsor Council of America. This number is up from only 58.2% in 2013.
