A wild Roth, an IRA, and a 401(K) appear!
Let’s talk about a really important and endlessly confusing topic: retirement accounts. Many of us have, at one point or another, worked at a company with benefits like a 401(k). You’re excited to take advantage of these perks until you go to enroll in the retirement plan and realize that it’s complicated. Like, really complicated. If you did what I did, you asked around, did some light Googling…and were still confused.
I completely understand. Doing research this past week on retirement accounts almost made me give up on this episode. I seriously considered having this episode just be me, ranting about how retirement plans are overly complicated. I promise it won’t be that…but bear with me because while I want these episodes to be informative and fun, I’ve gotta say it was quite challenging with this one. But have no fear, we’re going to get through this, because understanding our retirement plan options and feeling confident about contributing to them is key to making money moves!
Almost 70% of American workers think they don’t know as much about retirement as they should, which is probably at least partly why only 41% of those whose companies offer a 401(k) actually opt in to participate! In fact, a 2019 Government Accountability Office study found that almost half of Americans that are 55 years or older don’t have any sort of retirement funds! Even those who do have funds have about $163,000 or less in their funds at retirement age, which isn’t nearly enough – especially since we are living longer than ever.
Of course, the amount of money you need for retirement varies from person to person, but here’s what Fidelity Investments recommends: By age 30, you should have an amount equal to your salary saved in your retirement fund. By age 40, you should have three times that amount. By 60, eight times that amount and by age 67, ten times the amount of your salary. Or, if you’re starting at zero at age 30, Fidelity suggests putting aside 18% of your salary, and if you’re starting at 35, putting aside 23% of your salary.
I know that’s a lot of money… so if you’re freaking out right now – don’t worry! The good news is that even if you haven’t paid much attention to your retirement before, we’re working on educating ourselves and making better financial decisions now. I also talk more about how much money we need to save in this post!
Let’s start with going over the types of retirement accounts and what their similarities and differences are.
For most of us, our options are a 401(k), a Roth 401(k), a traditional IRA, and Roth IRA.
Put very simply, these are tax advantaged ways of putting money into investments that increase your savings for the future. This money can be accessed when you’re 59.5 years old, and withdrawing money before then can incur penalties or fees, depending on the situation.
Let’s start with the IRA options. IRA stands for Individual Retirement Account – well, actually, the IRS calls it an Individual Retirement Arrangement, but mostly everyone just calls it an account.
One key difference between an IRA and 401(k) is that 401(k)s are always established by an employer, while an IRA is something that is managed individually and is separate from any employer. So if your company doesn’t offer a 401(k) program, then an IRA will be the retirement account option for you! Or, if you had a 401(k) with a previous employer, you might roll your 401(k) into an IRA once you’re no longer with the company.
A 401(k) is the retirement account that’s established through your employer.
The term 401(k) comes from the section of the tax code that governs them, which started in the 1980s as a supplement to pensions. Some employers also offer a matching program, where they match your retirement account contributions up to a certain amount. There are companies that do require a certain period of employment before they will start these matching contributions. Let’s pause here for a second.
If your company is matching your contributions, do it! Take it! That is free money! Max out the matching contribution to get as much free money as you can. Again. It is free. money. Another great benefit of the 401(k) is that your employer will automatically put the money from your paycheck into the retirement account before there’s a chance for you to spend it!
So what are the other differences between the 401(k), Roth 401(k), traditional IRA, and Roth IRA, outside of being individually managed or company sponsored?
One difference is the amount you are allowed to contribute each year. In 2020, the 401(k) plans allow for up to $19,500 per year, or $26,000 for those older than 50. IRAs, the individual retirement accounts, only allow contributions of up to $6,000 per year, or $7000 per year if you’re older than 50. This means that if you are able to and plan on contributing more than $6,000 per year (which is about $115 per week), you might want to consider contributing to your company’s 401(k) program rather than an IRA program.
There are also income limits to a Roth IRA. This income limit is adjusted by the IRS annually and also depends on your filing status. For example, someone filing as single or head of household in 2020 would need to earn less than $124,000 per year in order to contribute the full $6,000 amount to their Roth IRA. If you earn more than that, you can only contribute a reduced amount, and if you earn more than $139,000 per year, then you aren’t eligible to contribute to the Roth IRA at all. The traditional IRA still has the contribution limit of up to $6,000 per year, but no income limitations. Withdrawal limitations are another area where they differ. I’ll go into this in more detail in a bit, but IRAs tend to be more flexible in withdrawing your money early, meaning before age 59.5, compared to 401(k)s.
Let’s pause here to quickly summarize the takeaways so far. The key differences between a 401(k) and IRA are whether it’s company sponsored or individually managed, the amount you can contribute each year, withdrawal limitations, and – for the Roth IRA – an income limitation to your contributions as well.
Moving on! We’ve got this Roth IRA and Roth 401(k). What does the “Roth” mean? It’s named after Senator William Roth of Delaware, who was the chief legislative officer for the Taxpayer Relief Act of 1997 which is why we have the Roth IRAs and 401(k) options today.
As the name suggests, the difference in these accounts is tax related. It means that the contribution to your retirement account, whether it’s an IRA or 401(k), is made after taxes, whereas in a traditional retirement account, you would contribute to your account pre-tax.
So how do you go about picking what might work best for you?
One way to answer that is whether you want your tax break now or later. That means it depends on what your current and future income looks like. If you’re earlier in your career and expect to move up in tax brackets in the future, maybe it makes more sense to go with a Roth 401(k) so that you’re paying taxes on your contributions now. Or, if you’re already in a higher tax bracket and think you may be easing off on work around retirement age, it might make sense to contribute to your retirement account pre-tax with a traditional IRA or 401(k), because that will reduce your current taxable income. It will then grow until you withdraw it at or after age 59.5, at which point you will pay income taxes on it.
The other big consideration is withdrawals, like I mentioned earlier.
How much should you have saved for retirement? Fidelity suggests that by age 30, you should have an amount equal to your salary saved in your retirement fund. Or, if you’re starting at zero at age 30, putting aside 18% of your salary.
Roth IRAs are the most flexible and allow you to withdraw your contributions at any time with no additional taxes or penalties. However, there is a Five Year Rule to withdraw your earnings. This means that in addition to waiting until 59.5 to withdraw your earnings, you also need to have had your account for 5 years in order to avoid penalties. This includes if you roll your Roth 401(k) into a Roth IRA! The date you open that Roth IRA is the date the 5 year clock starts running, no matter how long you had the Roth 401(k) previously. This just means that if you think you’ll roll your Roth 401(k) into a Roth IRA at some point in the future, you might want to look into opening a Roth IRA sooner rather than later so that you won’t be held up by the 5 year rule.
Traditional IRAs don’t have this 5 year rule and don’t allow early withdrawals without penalties except in certain circumstances. This includes some educational expenses, health insurance premiums if you’re unemployed, or buying a first-time home! On the other hand, withdrawing money from your 401(k) is a lot more restrictive. In fact, some 401(k)s won’t allow withdrawals at all if you’re still employed with the company!
I want to emphasize that withdrawing your money early is not recommended because it can get really expensive! For example, in addition to missing out on future earnings, you’ll most likely need to pay a 10% penalty plus income taxes if you withdraw from your 401(k) early. With Roth IRAs, for example, you can withdraw your contributions without paying a tax or penalty, but you may need to pay a tax and the 10% penalty to withdraw earnings, in addition to the 5 year rule I mentioned earlier. On the opposite end…every one of these accounts except for the Roth IRA also have what’s called a Required Minimum Distribution, or RMD. This is calculated based on your age and account balance but put simply, you have to start withdrawing money by age 72 from your 401(k)s and traditional IRA or else face more fees.
Yes, you heard me right. You’ll probably pay fees if you withdraw early…and you’ll also pay fees if you don’t withdraw early enough.
Do you see what I mean when I say this is insanely complicated? No wonder over 60% of Americans say they don’t know how retirement accounts work. On top of just the sheer options available and all the complicated terms, there are so many things – like management fees or additional types of retirement accounts available if you’re self employed – that I didn’t even touch on today.
Before your brain explodes, I have a few final – less confusing! – tidbits for you.
First – Figure out beforehand how much you can contribute towards your retirement and build it into your budget. Make it non-negotiable! Whether it’s through your company or your own individual account, set up automatic payments to resist any temptation to spend the money instead of saving it.
Second – You don’t have to pick just one type of retirement account. It’s possible to, for example, contribute to a 401(k) through your company and to a Roth IRA at the same time.
Third – I know that this might still be super confusing and the sheer number of options and the complexity of it all can be overwhelming! But. The important thing is to at least pick one and start contributing money to it. Even if it’s not the “perfect” option for you, that’s okay! You’re putting money towards your retirement, and that’s what is most important.
Finally. Why should we be contributing to a retirement account anyway? A lot of the benefit is the tax-related stuff. There are few investments out there that require as little active management and will outperform your retirement account’s investments and tax advantages over the long term!
Plus, think about how long we are living these days and how much it costs to live without any income. Don’t forget that as we get older, we will need money for additional care and support as well! We need to start saving now if we still plan on retiring around age 65 or want the option of not needing to rely on income at that age. Retirement accounts make sure that we’re not outliving our savings! If you need some more motivation to put money aside for savings, check out The B Word, where I talked about why it’s so hard to put money aside for savings and ways we can enjoy putting more money towards savings and retirement.