What the heck is a 401(k)/IRA/Roth and how do you get one?

So what is a 401(k), IRA or Roth? All of these numbers, letters and words can be scary and overwhelming. Basically, these are all just different types of requirement accounts. We will break down each account to help you decide which account is best for you.

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401(k)

A 401(k) is a basic retirement savings account that many employers offer. This account is a “defined contribution pension” where you invest towards your own retirement instead of your company providing a pension. Typically the way this works is you decide how much of your salary you will put into this account each year and the money in the account is invested. This contribution also reduces your income that is taxed so that you owe fewer taxes now. The catch to this type of plan is that you will pay tax on this money in retirement when you begin taking payments from this account. With this type of account, you are deferring your taxes until you retire. At age 70½ or the year after you retire, you will have to begin collecting payments from this account. Some jobs will offer a “match” where you can contribute a percentage of your salary, and your company will match some portion of that percentage.

The Problems

  • With this solution your retirement may be so far ahead in the future that it is impossible to predict what your tax bracket will be, at what age you will retire, or if your state will even tax income.
  • You cannot take the money out before you turn 59 ½ or you will have to pay a 10% penalty on top of regular income taxes on this money.
  • You will have less money in retirement (compared to investing in a Roth) if you are in a low income tax bracket now and are in a higher tax bracket at retirement.

The Bright side

  • You and your spouse can each contribute up to $17,500 to this type of account in addition to contributing to other retirement accounts like a Roth.
  • It is portable. You can switch jobs and roll it over into another account and take it with you. This contrasts a company defined benefit pension that pays you money based on how long you work at a company.
  • This is a great option to save for retirement if you cannot afford to both contribute to a retirement account and pay the taxes on your full current income. By contributing, you basically put off paying your taxes until you take the money out at retirement.
  • If you plan to retire before you turn 70 ½ and have little income, you will likely be in low tax bracket which makes this option attractive especially if you are currently in a high tax bracket.
  • If your company offers a match, you are getting free money to retire on! Even though you will pay taxes later, the money that your company contributes will cover your taxes and you will still have some of their money left over. If your company offers a match, take advantage of the full match before contributing to a Roth.

Traditional IRA

An IRA is a retirement option that your employer may offer or that you can open at most financial institutions. A traditional IRA is very similar to a 401(k). When you contribute to an IRA you get a break on taxes now and then pay taxes when you pull the money out. You will then pay taxes on every dollar you take out, which will include all of the growth and compounded interest from the account.  

The Problems

  • Unlike a 401(k), IRA’s have a maximum contribution limit of $5,500 per person. This is the maximum you can contribute to any type of IRA. If you have any combination of a Roth, a Simple IRA (where your employer matches your IRA) or a traditional IRA, the sum of all of these account contributions cannot exceed $5,500 per year.
  • If you are married and make over $191,000 or are single and make over $129,000, you cannot contribute to this type of account.
  • You have to start taking payments out of your account (called distributions) starting at age 70 ½ which means if you are still working, your taxes could be really high if you are in a high tax bracket.
  • To withdraw money penalty-free, you have to be age 59 ½ and that your first contribution be five years before the distribution begins.

The Bright side

  • If your employer doesn’t offer a 401(k) then you can still save for retirement by opening an IRA and you can do so at bank, credit union, or investment firm.
  • You can save for retirement even if you can only afford to contribute a small amount each month. This is because you get a tax break now which helps you save more money (like a 401k)

Roth IRA

A Roth IRA is a retirement account that you hold with your employer or on your own. The difference between a Roth IRA and any other type of retirement account is the way that this account is taxed. You are not given any tax break now and you will still pay your full income tax on any money that you earn and contribute. This account has already paid its taxes once and will never be taxed again. That means that all of your growth and the magic of compound interest will be yours forever.

The Problems

  • Similar to the traditional IRA, there is a maximum contribution limit of $5,500 per person. This is the maximum you can contribute to any type of IRA.
  • With a long term projection of how much money you will earn in Roth IRA versus a 401k or IRA that your company matches, the IRA/401(k) with a match wins out.
  • To withdraw money penalty-free, you have to be age 59 ½ and that your first contribution be five years before the distribution begins.

The Bright side

  • Roth IRA’s do not have a minimum distribution requirement. This means at no point in your lifetime will you be forced to take money out of your investments. This is because the government has already taken their share and has no further interest in the account.
  • If you are age 50 or older, catch up rules apply allowing you to contribute extra money to your IRA.
  • Money can be withdrawn penalty-free to cover first time home buyers costs and other qualified expenses (not that we recommend this).

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So how do you decide?

Consider all of the options. If your employer matches in any of these accounts, take the full match first. If you have money left over, consider a Roth but use your current tax bracket and future predicted tax bracket to really think about it. I used my current income and tax bracket with my future predicted tax bracket and plugged it into this calculator. You can see my results.Image

For me, the calculator says I would be better off with a traditional IRA. The difference between the two was only $1,500 which is less than a 2% gap. I am fortunate to make enough money with my spouse that I am in a pretty high tax bracket and I also qualify for good tax breaks that this calculator doesn’t factor in. In the long run, 2% isn’t a big enough deal to pull you hair out over. For my retirement, I’ve decided to hedge my bets and put 50% into a Roth and 50% into a 401(k), making sure that I take advantage of my entire 401(k) match. I am young and I can afford to start off risky/aggressive with the funds I choose and a target date fund is a good way to go because it becomes more conservative as you age. I can always change the proportions I contribute to each account and my investing strategy. Hopefully this will help you navigate the confusing world of retirement planning and help you make an informed decision on saving for your future.

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