"Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn't, pays it."
– Albert Einstein
Planning for retirement often feels pointless. You’re young and your startup is taking off — why should you worry about retirement now?
There are two concepts that make this planning a no-brainer:
Interest on interest unlocks exponential growth. If you earn 5% annual interest on a $10,000 deposit, you’ll have $10,500 after the first year. In the second year, you’ll earn interest on the initial deposit plus interest on the interest you earned. And so on. Over 50 years, a 5% compounded interest rate will grow your $10,000 deposit to over $110,000. The earlier you start, the more time your money has to grow.
2. Tax-advantaged accounts
The government provides opportunities to invest tax-free in the stock market through retirement accounts. While beating the stock market is hard, maximizing your contribution to tax-advantaged investment accounts provides an instant increase to your future returns.
Compounding, tax-free returns generate long-term wealth. Combining these tools with a broader asset allocation strategy will help you manage uncertainty (e.g., handling a global pandemic) and achieve your financial goals. This guide explains how to make the most of these tools. We’ll cover the different types of retirement accounts and how to strategically optimize your contributions.
A Quick History of Retirement Planning in America
2 min read
The government offers tax incentives for retirement planning. This motivates citizens to plan for the long term and reduces the government's burden in providing late-career financial support.
Modern retirement planning really started to take off during World War II, when wage freezes and tax increases made the tax benefits of employer-sponsored retirement plans especially attractive. Soon, retirement benefits became a key tool for companies to recruit new employees. Between 1950 and 1970, the number of workers covered by employer-sponsored retirement plans more than doubled.
In 1974, Congress passed the Employee Retirement Income Security Act (ERISA), which reformed the structure of existing plans and formally established
the 401(k)So named because the plan is defined in section 401(k) of the Internal Revenue Code
plan, which is the most popular type of corporate retirement benefit today. In this law, Congress also established the legal framework for another type of retirement account called the individual retirement account (IRA), which allowed individuals to save for retirement and reap tax benefits without the need for a corporate sponsor.
Today, the most common plan types are 401(k)s and IRAs. Some reports suggest that employees miss out on an estimated $24 billion every year by not taking full advantage of these plans. This guide helps you understand your options so you don't leave anything on the table.
Retirement Account Types
All retirement accounts — 401(k)s and IRAs — share some basic characteristics:
1. Tax advantages
Both you and your employer can save on taxes with these accounts.
2. Contribution limits
Without contribution limits, these retirement accounts could easily be repurposed as huge tax shelters for the ultra-wealthy.
3. Restrictions on withdrawals before age 59 ½
Without an age restriction, these accounts would be no different from normal taxable accounts apart from their tax advantages, and they wouldn't encourage long-term saving.
We'll go over the specific details of each of these characteristics as they relate to each account type below.
401(k) plans are the most common type of retirement plan offered by employers. Under a 401(k), you tell your employer to redirect a certain amount from your paycheck to your 401(k) account instead.
There are two types of 401(k)s, Roth and Traditional:
You can only contribute to a 401(k) through your paycheck (so you need to be employed). You can contribute up to $20,500 per year across all your 401(k)s. You can contribute no matter how much money you make.
A withdrawal before 59 ½ is subject to a 10% penalty in addition to any taxes you may owe. For a Roth 401(k), only gains are subject to the 10% penalty and ordinary income taxes. However, when you withdraw, the amount is prorated between gains and contributions, so there's no way to make a penalty-free withdrawal from an account that has experienced growth.
A withdrawal before 59 ½ is subject to a 10% penalty in addition to any taxes you may owe.
For a traditional 401(k), the full pre-tax amount is subject to the 10% penalty and ordinary income taxes.
How Tax Savings Work
You pay ordinary income taxes on what you contribute now.
The contributions grow tax-free in the 401(k).
You pay ordinary income taxes when you make withdrawals from the account. You deduct the amount that is withheld from your paychecks from your taxable income for the current year.
Your company may offer 401(k) matching. For instance, if you elect to contribute $2,000 from your paycheck to your 401(k), your employer might put $2,000 in too so the ending balance on your account after the pay period would be
$4,000 higherUsually, your employer will say something like "we'll match 6% of your paycheck." If you make $100,000 a year, that means if you contribute $6,000, your employer will also contribute $6,000. Your employer won't contribute any more than that, but you're free to contribute more from your own paycheck for greater personal tax savings.
. You should always take advantage of the full match — it's free money!
You can invest the money in your 401(k) account from the selection of products (e.g., mutual funds) offered by your company's 401(k) plan administrator, typically a firm such as Fidelity or Vanguard. These products might be less appealing than what you'd get elsewhere, but it's all up to the plan administrator and generally not something you can control. It's also important to keep in mind that returns might be lower on these products due to administrative fees — which is one benefit of a separate individual retirement account (IRA).
When you leave your job, you can take your 401(k) with you. You can either move the funds into your new employer's 401(k), or move the funds into an individual retirement account (IRA). Generally, moving the funds into an IRA is a better decision (explained below).
Individual Retirement Accounts (IRAs)
Individual Retirement Accounts (IRAs) offer tax advantages like a 401(k), but don't need to be sponsored by an employer. Like a 401(k), they can be classified as either
RothSo-named because they were established by legislation championed by former Senator William Roth of Delaware.
Up to $6,000 across all IRAs (both types).
Roth IRAs are restricted to those who make less than a certain amount of employment income. If you make more than the Roth income limit you are only able to contribute to a traditional IRA.
As of 2020, a single person making more than $139,000 a year is prohibited from contributing to a Roth IRA. Those who make less can contribute an amount that is phased-out based on income thresholds. You can determine the exact amount you are permitted to contribute based on your income on the IRS website; anything else you'd like to contribute, up to $6,000, must be contributed to a traditional IRA instead.
Up to $6,000 across all IRAs (both types).
You can contribute no matter how much money you make.
A withdrawal before 59 ½ is subject to a 10% penalty in addition to any taxes you may owe. For a Roth IRA, only gains are subject to the 10% penalty and ordinary income taxes. Contributions are considered to be withdrawn first, so penalty-free withdrawals from a Roth IRA that has experienced growth are possible, unlike a Roth 401(k). This flexibility is one reason why you might want to set up a backdoor Roth IRA (explained below).
A withdrawal before 59 ½ is subject to a 10% penalty in addition to any taxes you may owe. For a traditional IRA, the full pre-tax amount is subject to the 10% penalty and ordinary income taxes.
How Tax Savings Work
You pay ordinary income taxes on what you contribute now. The contributions grow tax-free in the 401(k).
You pay ordinary income taxes when you make withdrawals from the account. You may be able to deduct the amount that is withheld from your paychecks from your taxable income for the current year. There are restrictions. As of 2020, if you make over $75,000 and contributed to an employer-sponsored 401(k), you can't deduct any of what you contribute to a traditional IRA. If you make less than $75,000, you can get a phased-out deduction. With that, opening a separate traditional IRA generally isn't immediately necessary for high earners if they already have access to a solid 401(k) plan with matching through their employer.
Note that unlike a 401(k), whose contribution limits reset every calendar year, the length of a "year" for contribution limit purposes for IRAs is actually fifteen months. You can make IRA contributions for a given tax year until the tax filing deadline for the year. That means that between January 1 and April 15 of the following year (tax day), you can contribute to your IRA for either the current year or the previous year.
Also, you can only contribute to an IRA if you have employment income. If your total income this year was $1,000 from freelancing and $100,000 from investments, you'd only be able to contribute $1,000 to your IRAs.
You can invest the money in your IRA account in the investment options (stocks, bonds, mutual funds, etc.) offered by the provider of your IRA. This will often be a better selection of options than what you'd get through your 401(k).
Self-Directed IRAs (SDIRAs)
A self-directed IRA (SDIRA) is not a separate IRA type per se, since an SDIRA can be either Roth or traditional.
SDIRAs are offered by specialized firms. You would open one if you wanted to invest in assets other than the basic stock and bond products offered by a regular IRA provider like Fidelity or Vanguard. Depending on which firm you work with, they might support alternative investments like real estate, cryptocurrency, and startup equity. An SDIRA allows you to hold these assets in a tax-advantaged way, in the same way a regular IRA allows you to hold stocks and bonds in a tax-advantaged way.
For example, let's say you open a self-directed Roth IRA and fund it with $6,000. Then, you invest that money in a real estate partnership. Next, the partnership buys a fourplex in Los Angeles and rents it out to four tenants. Any rental income you receive from that property will accrue in the account and you won't have to pay taxes on it, and if the property appreciates and you sell it, you won't have to pay capital gains taxes either — since growth in a Roth IRA is tax-free.
On the equity side, PayPal co-founder Max Levchin allegedly has almost $100 million of tax-free gains in his self-directed Roth IRA from the appreciation of his startup stock.
SDIRAs are less common than their regular IRA counterparts at Vanguard or Fidelity, but for people with long time horizons to retirement, the alternative investments they allow can help provide better returns (alpha). We'll talk more about this below under "Diversification".
Despite the complexity of all these different plan and account types, for most people, planning for retirement is pretty simple.
To start, you'll need to decide how to allocate your savings between the different plans — how much to contribute to your 401(k), and if you are able to or should contribute to your IRAs. Then — depending on your plan's offerings and what your income allows — you'll need to decide the type of account:
The Roth 401(k) is a relatively new invention, so your employer's 401(k) administrator may not offer it. If that's the case, you're stuck with the traditional option. Also, unlike a Roth IRA, a Roth 401(k) has no income limits — you can contribute to a Roth 401(k) no matter how much money you make.
or traditional. Consider:
Does your company offer a 401(k) plan and do they match your contributions? If yes, take advantage of the full match first. The immediate 100% return you get on the matched funds is better than almost anything else you'd get in the markets.
Do you think you'll be in a higher tax bracket now or when you retire? If you think you're going to be in a lower tax bracket in retirement, deferring taxes now through a traditional 401(k) or IRA makes more sense so you pay taxes in that lower retirement bracket when you withdraw. If you're very early in your career and think you're going to be in a higher tax bracket by the time you retire, Roth versions of those accounts make more sense, so you avoid taxes in that higher retirement bracket when you withdraw.
Most people in tech are highly compensated (i.e. their retirement tax bracket will likely be lower than their current tax bracket — a good rule of thumb is whether you make
Here's an example. Let's say you plan to live on $100,000 a year in retirement (a relatively cushy amount). In 2021, that would put you in the 24% bracket. If you make over $164,926 (the cutoff for the next bracket, 32%), you should defer your taxes to retirement.
) and work for companies with generous 401(k) matching. If that sounds like you, your playbook looks something like this (the order is important for maximum tax savings):
Opt for a traditional 401(k):
Deferring taxes until retirement makes sense since you're currently in a high tax bracket.
Maximize your match:
Contribute as much as you can to your 401(k) to take full advantage of your employer match. Ideally, the maximum of your employer match should be the minimum that you set aside for retirement — otherwise, you're leaving money on the table.
Continue contributing to your 401(k):
If you can afford to save even more for retirement, keep contributing to your 401(k) until you hit the $20,500 limit to get the maximum tax deduction.
Contribute to a backdoor Roth (advanced):
Contributing to a traditional IRA doesn't make sense if you've already contributed to a 401(k) since there's no extra tax deduction, so if you can afford to save more than $20,500, contribute up to $6,000 to a post-tax Roth IRA via the backdoor Roth procedure explained below.
Contribute to a mega-backdoor Roth (advanced):
This procedure allows you to contribute up to $37,500 extra to your Roth IRA by making after-tax contributions to your 401(k). It's a complex process and not all 401(k) plans allow it. If you are able to set aside this amount of money for retirement, we recommend that you get a financial advisor to help you through this.
Compound provides personalized financial management, which includes tools to automate your personal financial playbook.
Once you fund your 401(k) or IRA, you will need to invest the cash into assets that will grow and compound for you. You should optimize your portfolio in the context of your broader asset allocation strategy. This varies — some people may be comfortable with a portfolio consisting entirely of the S&P 500, while others may want a more conservative mix.
Regardless, don't check your balance too often (it'll stress you out), keep buying as you contribute to the accounts, and ride the ups and downs until you're ready to retire. Over very long time horizons, the overwhelmingly important factor for reaching retirement success is consistent saving and holding.
Here's a quick example. Over the last ninety years, the S&P 500 has returned about 10% per year. Let's say you set aside $50,000 per year for retirement over a twenty-year career —
This is a lot and should be interpreted as an aspirational amount! But it helps to illustrate the amazing power of long-term compounding.
in a 401(k) and $6,000 in a backdoor Roth. Here's what your balances would look like each year:
Roth IRA Balance
Estimated Spendable Balance
Estimated 20% retirement tax bracket
You can scroll right on the table above →
At the end of twenty years, you'd have contributed $50,000 * 20 years = $1 million to your retirement accounts. However, your spendable balance would be close to $2.5 million — enough to support
To be fair, we haven't accounted for inflation. Assuming 2% inflation per year, $100,000 in twenty years is worth about $70,000 now. It's not 100 grand, but still a very comfortable sum to retire on!
a year of retirement spending at a 4% withdrawal rate — through the power of compounding. Follow the plan — buy and hold — that's really it!
Below, we'll cover some nuances that are good to be aware of as you progress in your career and get closer to retirement.
Moving Between Accounts
You might consider moving between accounts or account types if your tax situation changes. There are some restrictions on what types of accounts can be rolled over — traditional accounts can be rolled over into Roth accounts, but Roth accounts can't be rolled over into
Converting from a Roth IRA to a Traditional IRA (a process known as "recharacterization") was banned by the Tax Cuts and Jobs Act in 2017
As an example, converting from a traditional IRA to a Roth IRA during a year when your income is unexpectedly low or after a big market crash (since there's less to tax) could be a smart move, especially if you're confident that your tax bracket in the current year will be lower than in retirement. If the existing traditional IRA is especially large, you can also choose to convert only part of the account and spread it out over a few years to stay in a lower tax bracket. Note that when you convert, you'll generally be taxed on the full value of the traditional IRA conversion amount since all those funds are still pre-tax.
Converting a 401(k) to an IRA is common for those who recently left or switched jobs. Unfortunately, you generally can't move money out of a 401(k) before leaving your job. In general, if you get a new job, rolling over from a 401(k) into an IRA is a better choice than rolling it over into your new employer's 401(k) for the wider investment options and lower fees you get in an IRA. Whether to choose Roth or traditional, again, depends on your current income and whether you'll be in a higher or lower tax bracket in retirement.
Like traditional IRAs, Roth IRAs have restrictions on withdrawals. However — unique to the Roth IRA — it's only withdrawal of the earnings that are subject to a penalty. That is, if you contribute $6,000 to your Roth IRA on January 1st, and it grows to $6,600 on December 31st, you can withdraw $6,000 from the account without any penalties since it was your contribution (note, you generally don't want to withdraw since you can't put the contributions back in, and you want your money to grow as much as possible in the account tax-free). As soon as you withdraw the next dollar though, since it exceeds the amount you contributed, you'll be hit with the 10% penalty and income tax.
Nonetheless, this flexibility to withdraw, along with the possibility of unlimited tax-free growth, is one reason why you may still want to contribute to a Roth IRA even if your income is above the limit. You can get around the income restriction through the "backdoor Roth" process: you contribute to a traditional IRA (which has no income limits), and then roll the traditional IRA over into a Roth IRA. The tactic is completely legal, and financial advisors are familiar with it.
The name "backdoor Roth" might make more sense with an example: say you open a new traditional IRA on January 1st, fund it with $6,000 on January 2nd, and initiate the Roth conversion on January 3rd (it's generally good to wait a day between each step so the IRS can see a clear process, but you should consult a tax advisor). On January 4th, you'll have a Roth IRA with $6,000, even if your income is above the limit, and the tax implication is the same as if you'd contributed to the Roth directly, since you took no tax deduction for the contribution and the value of the account didn't grow.
As mentioned above, you can optionally increase diversification by investing in other uncorrelated asset classes through an SDIRA. Real estate and crypto are emerging vehicles for retirement savings (some advisors recommend up to a 20% allocation to real estate; Fidelity recently issued a report saying bitcoin was "potentially useful" for uncorrelated return-seeking investors), and can provide excess returns outside of what you'd get solely in public equities, although they may increase your volatility if you're not careful. There are also certain rules specifically regarding real estate in IRAs that you need to be careful about; for instance, you can't use the property for yourself at all, and staying even one night might compromise the property's tax-advantaged status.
Working for a startup and taking a lower salary now in exchange for equity can be thought of as another way of adding risk to your “personal portfolio.”
Compound can help you optimize your risk and automate these playbooks to unlock long-term wealth.