Tag: Financial knowledge
401K Explained in தமிழ் (US Retirement Series – 1)
Jason 0 Comments Retire Wealthy Retirement Planning
This episode and next few episodes are going to be US specific episodes. All these US specific episodes will have US flag in their thumbnails. Indian audience, feel free to skip these episodes and save your time. US folks, there are 2 main retirement plans in USA. 1. 401K and 2. IRA. We will cover more in detail about IRA in another episode. In this episode, we will cover 401K in detail. Hi. My name is Vijay Mohan. You are watching – Investment Insights. 401K is a retirement plan offered thru employer.
We will not be able to open a 401K account just by ourself like a brokerage account. We can contribute to a 401K, only if it is offered through our employer. Almost all employers offer 401K plan. Very few small companies do not offer 401K. How much can we contribute to a 401K? Each employee can save up to $20,500 per year. If husband and wife both are working, both can contribute $20,500 each. People older than 50 can contribute more – $27,000/year. That is called as "Catch up contribution". Other than our contribution to 401K, many employers match up our contribution up to certain percentage. Let's say that an employer is matching up to 7%. If our salary is $100K, 7% of that would be $7,000. Let's say that we are contributing $20,500 to our 401k and maxing it out. Employer would have matched up the first $7,000 of that $20,500 and would have contributed that $7,000 to our 401K.
So in total, our contribution $20,500 + employer match up contribution $7,000 = $27,500 would have gone into our 401K account. Employer match of $7,000 would not come under the contribution limit of $20,500. This match is over that contribution limit. In this employer match, each employer has a catch called "Vesting Schedule". This vesting schedule defines when that extra amount matched up by the employer is going to actually credit in our account. Let's say that an employer has a vesting schedule of 2 years, then in that 2 years, the match up amount contributed by the employer will be in our account, but not vested. That means, if we leave the job within the 2 years of joining, then we will not get that matched up amount. But after 2 years, that matched up amount will be ours totally, even if we leave the job. Also, after that vesting period of 2 years, all money matched up by the employer will be vested (available) to us immediately. That means, there will not be any restriction over the matched up money after passing 2 years.
The 2 years I am referring here is just an example. It will be different for every employer. So what is the advantage to us from this 401K? The advantage is, we do not have to pay the tax on the amount we are contributing to 401K. But we should pay tax on withdrawal after retirement. What? No tax for the contributed money, but taxed on withdrawal? What benefit does that offer to us? Good question. To understand that, we should know about our tax bracket.
What we are seeing here is 2022 Married Filing Jointly tax bracket. Let's say that our family income is $120,000. We will come under 22% tax bracket. That does not mean that we will be paying 22% tax for the whole $120,000 we earned. First 20,000 of $120,000 will be taxed at 10%. Next 63,000 will be taxed at 12%. Money earned over that will be taxed at 22% tax. So the 22% tax is charged for the top most dollar we made in that year. This is called as Marginal Tax rate. If we add up all the taxes for individual brackets of 10%, 12% and 22%, that comes out to $17,634. This is 14.7% of our total income $120,000. So actually we are paying only 14.7% of our income as tax. This 14.7% is called "Effective Tax Rate". May confuse between marginal tax rate and effective tax rate. Hope it is clear now. So when we contribute $20,500 to our 401K, it comes out of our top most tax bracket. That means, the tax we saved from the contribution of $20,500 is 22%. $4510. If we withdraw the same $20,500 after our retirement, the tax rate for that would be 10%.
Tax saved for contribution is 22%, while money coming out is taxed at 10%. The difference is 12% in our favor. Or in other words, we save tax in marginal tax rate for contribution and we pay effective tax rate while withdrawal. We all know that effective tax rate will be always lower than the marginal tax rate. This is first advantage. Let's check out a sample calculation to understand the next advantage. Let's say that our family income is $120,000. Then federal marginal tax rate is 22%. Let's use Illinois state tax rate – 5%. For 401K contribution, not just the federal tax, we don't have to pay the state tax as well. Let's assume that our 401K will be growing at 8% growth rate.
We are maxing out our 401K contribution every year by contributing 20,500/year. Tax savings from this contribution is 27%. $5535. We are continuing to do this till our retirement for 25 years. By the end of 25 years, our 401K balance would have reached 1 million 600,000 dollars. The $5535 that we saved every year in tax alone would have grown into $437,000. The absolute tax saved is 5355 * 25 = $138,000. The growth from that savings is approximately $300,000. Or in other words, just because we did not pay (deferred) the tax of $138,000, the extra growth we got from that is $300,000. The growth of money by deferring (not paying the tax now) the taxes to pay later is called as "Tax deferred Compounding". This tax deferred compounding is 401K's second advantage. For these 2 advantages, we can contribute to 401K. We should. So far we have seen a regular pretax 401K. There are other flavors of 401K like Roth 401K and After tax 401K. We will dig deeper into that in the next episode. Thank You..
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Building Wealth (Ep.2) – Delayed Gratification (தமிழ்)
Jason 0 Comments Retire Wealthy
We went through the importance of "Developing Financial Knowledge" in the last episode. If you have not watched it yet, please watch that first. Today we are going to watch the second episode in the series "Building Wealth". Delayed Gratification Gratification means – We all have our own desires right? When we attain those desires, we get this great satisfaction right? That satisfaction is what is called "Gratification" in English. "Isn't attaining our desires is a good thing? Why should we delay?" – you ask. Explaining that is the purpose of this episode. If "Financial Knowledge" is the architect of building wealth, "Savings Rate" is its foundation. Our foundation will be as strong as our savings rate. We already know this from "Financial Freedom" episode. Most of us will achieve 20% savings rate easily. But to go beyond that, we need to know some strategies. Normally what we do is, we keep upgrading our lifestyle in line with our earnings. We will be with four roommates when we start working.
In 2-3 years, our salary will double. When that happens, we upgrade ourselves from 4 room mates to 1 room mate. Then in 2-3 years, we get married. Then we upgrade ourselves to a one bedroom apartment. Then in 2 years, we upgrade to a two bedroom apartment. Then after kids, we buy our own home. So depending on our career growth, we keep upgrading our lifestyle. Then expenses add up with kids, school fees and so on. It never comes down. After 40 years, we will come to a sudden realization, that we have crossed half our life time, but all that left is just our home as asset.
We start thinking about retirement and investments only after that. But by that time, we will have other responsibilities. Saving for kids college, marriage become our priorities. Just like that, our life would just pass away. Next generation will follow the same pattern as well. How can we build wealth if we live like this? Life of a US settled person is also very similar to this. But they do one more thing after 40. They sell their current home and upgrade to a bigger home. So we are keep upgrading our life style depending on our financial growth from our career. Regardless of how much we earn, we spend to match that earnings growth.
If we want to break this cycle and move to next level, there is just only one option. That is – Delayed Gratification. That is – instead of enjoying the life upgrades immediately we can postpone it to some time, and attain financial growth. Before we check out on how we can do that, a small tidbit about "Delayed Gratification". In 1960's, Stanford University conducted a psychological experiment called "Marshmallow Experiment" with kids.
Marshmallow is something that looks like a thicker version of Cotton Candy. It is white and super sweet. Kids love it. They used 3.5 to 5.5 years old kids for this experiment. What they did was, They asked a kid to stay inside a room and they put a marshmallow on a plate in front of them. They made a deal with that kid. The deal is – I will leave the room now. But will be coming back after 15 mins. If you have not eaten the marshmallow by the time I come back, you will get two marshmallows instead of one. So – the kid has two choices. There is a marshmallow right in front of kid's eyes. Instead of waiting for another marshmallow for 15 mins, the kid can eat one right now. Or wait for 15 mins and eat two marshmallows instead of one. When we hand over a fish to a cat, is it possible for the cat not to eat the fish? 7 out of 10 kids ate the marshmallow immediately. But 3 out of 10 kids controlled their temptation and waited for the second marshmallow successfully.
Stanford University did not stop their research at that. They followed these kids for 40 years to see how they are doing in their life. The kids who waited patiently settled better in their life. They did well in their college entrance exams. They did not fall addicted to any drugs. They did not have obesity issues. They used their "Self Control" capability totally to their advantage. What we learn from here is, people who have a strong mindset and who do not get distracted easily are very disciplined and they set up a goal for themselves and attain it as well. They do not think in short term. They plan for long term and achieve it successfully.
We will see this "Long Term Planning" more in detail in another episode. Coming back to our topic – "Life Upgrade" How many upgrades do we see in our adult life? We upgrade from 4 room mates to 1. We upgrade from 1 room mate to separate apartment. From 1 BR we upgrade to 2 Bedroom. From 2 Bedroom, we upgrade to own house. Even for own house, we again upgrade to a bigger home. All these are housing upgrades. Like this, We upgrade from pubic transportation to bike. From bike to car. From car to luxury car. These are upgrades in our personal vehicle. We don't do these upgrades without a reason. We do it to match our earnings. If we do not upgrade our life styles along with our earnings growth, but delay it by 2 to 3 years – what happens then? The salary rise will go directly to our savings rather than for life upgrades and will increase our savings rate.
If the savings rate increases, the foundation of "wealth building" will be super strong. Think about it. If our whole life is 80 years, Its not really a big deal to delay our upgrades for 3-5 years. We are going to attain all these anyways. Its just that we are going to do it bit later. So, we have two choices. 1. Live in the moment by upgrading our lifestyle depending on our earnings growth. Or 1. Postpone the upgrades for a while and use that savings to build a strong nest egg so that we can even pass our wealth to next generation.
The choice is ours. Now we can see the benefits that we can get out of "Delayed Gratification" at high level. We will see how we can apply this strategically in different stages of life in next episode. Thank You..
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401K Explained in தமிழ் (US Retirement Series – 1)
Jason 0 Comments Retire Wealthy Retirement Planning
This episode and next few episodes are going to be US specific episodes. All these US specific episodes will have US flag in their thumbnails. Indian audience, feel free to skip these episodes and save your time. US folks, there are 2 main retirement plans in USA. 1. 401K and 2. IRA. We will cover more in detail about IRA in another episode. In this episode, we will cover 401K in detail. Hi. My name is Vijay Mohan. You are watching – Investment Insights. 401K is a retirement plan offered thru employer. We will not be able to open a 401K account just by ourself like a brokerage account. We can contribute to a 401K, only if it is offered through our employer. Almost all employers offer 401K plan. Very few small companies do not offer 401K. How much can we contribute to a 401K? Each employee can save up to $20,500 per year.
If husband and wife both are working, both can contribute $20,500 each. People older than 50 can contribute more – $27,000/year. That is called as "Catch up contribution". Other than our contribution to 401K, many employers match up our contribution up to certain percentage. Let's say that an employer is matching up to 7%. If our salary is $100K, 7% of that would be $7,000. Let's say that we are contributing $20,500 to our 401k and maxing it out. Employer would have matched up the first $7,000 of that $20,500 and would have contributed that $7,000 to our 401K. So in total, our contribution $20,500 + employer match up contribution $7,000 = $27,500 would have gone into our 401K account. Employer match of $7,000 would not come under the contribution limit of $20,500. This match is over that contribution limit.
In this employer match, each employer has a catch called "Vesting Schedule". This vesting schedule defines when that extra amount matched up by the employer is going to actually credit in our account. Let's say that an employer has a vesting schedule of 2 years, then in that 2 years, the match up amount contributed by the employer will be in our account, but not vested. That means, if we leave the job within the 2 years of joining, then we will not get that matched up amount. But after 2 years, that matched up amount will be ours totally, even if we leave the job. Also, after that vesting period of 2 years, all money matched up by the employer will be vested (available) to us immediately. That means, there will not be any restriction over the matched up money after passing 2 years. The 2 years I am referring here is just an example. It will be different for every employer. So what is the advantage to us from this 401K? The advantage is, we do not have to pay the tax on the amount we are contributing to 401K.
But we should pay tax on withdrawal after retirement. What? No tax for the contributed money, but taxed on withdrawal? What benefit does that offer to us? Good question. To understand that, we should know about our tax bracket. What we are seeing here is 2022 Married Filing Jointly tax bracket. Let's say that our family income is $120,000. We will come under 22% tax bracket. That does not mean that we will be paying 22% tax for the whole $120,000 we earned. First 20,000 of $120,000 will be taxed at 10%. Next 63,000 will be taxed at 12%. Money earned over that will be taxed at 22% tax. So the 22% tax is charged for the top most dollar we made in that year. This is called as Marginal Tax rate. If we add up all the taxes for individual brackets of 10%, 12% and 22%, that comes out to $17,634. This is 14.7% of our total income $120,000. So actually we are paying only 14.7% of our income as tax. This 14.7% is called "Effective Tax Rate". May confuse between marginal tax rate and effective tax rate. Hope it is clear now. So when we contribute $20,500 to our 401K, it comes out of our top most tax bracket.
That means, the tax we saved from the contribution of $20,500 is 22%. $4510. If we withdraw the same $20,500 after our retirement, the tax rate for that would be 10%. Tax saved for contribution is 22%, while money coming out is taxed at 10%. The difference is 12% in our favor. Or in other words, we save tax in marginal tax rate for contribution and we pay effective tax rate while withdrawal. We all know that effective tax rate will be always lower than the marginal tax rate.
This is first advantage. Let's check out a sample calculation to understand the next advantage. Let's say that our family income is $120,000. Then federal marginal tax rate is 22%. Let's use Illinois state tax rate – 5%. For 401K contribution, not just the federal tax, we don't have to pay the state tax as well. Let's assume that our 401K will be growing at 8% growth rate. We are maxing out our 401K contribution every year by contributing 20,500/year. Tax savings from this contribution is 27%. $5535. We are continuing to do this till our retirement for 25 years. By the end of 25 years, our 401K balance would have reached 1 million 600,000 dollars. The $5535 that we saved every year in tax alone would have grown into $437,000. The absolute tax saved is 5355 * 25 = $138,000. The growth from that savings is approximately $300,000. Or in other words, just because we did not pay (deferred) the tax of $138,000, the extra growth we got from that is $300,000.
The growth of money by deferring (not paying the tax now) the taxes to pay later is called as "Tax deferred Compounding". This tax deferred compounding is 401K's second advantage. For these 2 advantages, we can contribute to 401K. We should. So far we have seen a regular pretax 401K. There are other flavors of 401K like Roth 401K and After tax 401K. We will dig deeper into that in the next episode. Thank You.
Read MoreBuilding Wealth (Ep.2) – Delayed Gratification (தமிழ்)
Jason 0 Comments Retire Wealthy
That is – rather of enjoying the life upgrades quickly we can postpone it to some time, as well as obtain financial growth. From 1 BR we update to 2 Bedroom.From 2 Bed room, we upgrade to have residence. If our entire life is 80 years, Its not truly a huge bargain to delay our upgrades for 3-5 years.We are going to acquire all these anyways.
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