I’ve mentioned retirement savings in several earlier posts, but I thought I would circle back and go over some of the different types of plans/accounts you can use to save for retirement. After all, most people aren’t taught even the most basic level of personal finance when they’re in school. The options are often confusing and overwhelming.
I don’t want you to give up on saving for retirement simply because it’s too complex. So, let’s take a look at some of the basic differences between the types of accounts available to you.
A 401(k) is probably the most common type of retirement account in the U.S.. Its called a 401(k) because 401(k) is the section of the Internal Revenue tax code that makes this account possible.
401(k)s are available through employers. Actually, though they’re offered by most large employers in the U.S., only 49% of employed workers have access to a 401(k).1 What accounts for this discrepancy? Well, many people work for small companies, and those companies often don’t offer 401(k)s.
I actually work for a very small company, and I was there for 4 years before the owner of the company gave me (and my co-workers) access to a 401(k).
The whole system is really a bit unfair, but we’ll get into why I think that in a bit.
Anyway, when employees have access to a 401(k), they can choose to have a certain percentage of each paycheck go towards their 401(k). As an employee, you don’t really have any control over the types of investments available to you through this account. Well, you don’t have any direct control, but you can speak with or write to your HR rep, or whoever is managing the 401(k) for your company. Hopefully they’ll listen to you if you have reasonable issues with the types of investments available to you.
Additionally, your employer has a legal obligation to monitor the 401(k) they offer and make sure the expenses are reasonable. Here’s a direct quote from the Department of Labor:
“…fiduciaries must establish a prudent process for selecting investment alternatives and service providers to the plan; ensure that fees paid to service providers and other expenses of the plan are reasonable in light of the level and quality of services provided; select investment alternatives that are prudent and adequately diversified; and monitor investment alternatives and service providers once selected to see that they continue to be appropriate choices.”2
If you think the investments available through your 401(k) have fees that are too high, you can call the Department of Labor at 1-866-444-3272. They’ll do an investigation if they think it’s warranted.
Many employers who offer a 401(k) offer a match. The type and amount of match can vary widely. However, a common match is $.50 on each dollar that you invest up to 4% of your total salary. So for example, if you make $50,000 a year, and invest 4% of that, your total investment would be $2,000 that year. If your company was giving you $.50 on the dollar, they would be putting in another $1,000.
401(k) contributions come out of your pre-tax income. So, these contributions lower the total amount that you need to pay in taxes for the year. The catch is that your taxes are only postponed, and you’ll need to pay taxes when you withdraw the money. If you withdraw the money prior to when you hit age 55, you’ll also have to pay financial penalties. There are some exceptions to these penalties. Three of these exceptions are:
- Using the money towards the purchase of a first home.
- Using the money for a medical emergency.
- Using the money for higher education.3
But in general, it’s not a good idea to take money out of your 401(k) before retirement.
As of 2015, you can contribute up to $18,000 dollars per year towards a 401(k).4 If you are 50 or older, you can contribute up to $24,000.
As a side note, I don’t particularly agree with the way 401(k)s are handled in the US. I think the pension system was probably much better for employees, as it guaranteed they would have a certain income in retirement. Now, people without any financial training have to take control of their own investing. And they’re not protected nearly as much as they were with pensions.
And I think it’s awful that you can only contribute $5,500 per year to a Roth or Traditional IRA, but you can contribute more than three times as much to a 401(k). So, you are essentially at the mercy of your employer. Plus, if you’re an independent contractor, you have to set up a solo 401(k) in order to contribute as much as people who work at companies that offer 401(k)s. This seems like it would dissuade people from starting their own businesses.
And people in their 30s like me are told we can’t rely on Social Security being there when we want to retire – even though we’ll be contributing to it our whole lives!
In my opinion, this system is extremely flawed and actually discourages entrepreneurship. But it’s the system we have. So, the best thing I can do is train you guys and give you the tools to take control of your retirement.
Next, let’s take a look at IRAs.
IRA stands for Individual Retirement Arrangement. These are the only type of retirement accounts available to many people. As opposed to 401(k)s, these types of accounts are usually not offered by your employer and can be opened by individuals. The only requirement is that you have earned income for the year in which you are making the contributions.
The maximum that you can contribute to both a traditional and Roth IRA is $5,500 as of 2015. If you are 50 or older, you can contribute a maximum of $6,500.5
A traditional IRA has some similarities to a 401(k). Any investments to a traditional IRA come from pre-tax income, and taxes must be paid when you withdraw your money. As with a 401(k), there are no income limits, so you can take advantage of this type of account no matter how much money you make.
If you leave a job where you participated in a 401(k), you can roll the funds from that 401(k) into a traditional IRA without paying any taxes or penalties. This is what I did back in 2008 when I got laid of from my job. I had to open a traditional IRA account through Fidelity to do so, but that was pretty painless.
The Roth IRA is my favorite type of retirement account. With this type of account, you are contributing post-tax income. So, you don’t get the tax break upfront that you get with 401(k)s and traditional IRAs. But the great part is you don’t pay any taxes when you withdraw from the account. Your initial investment and your earnings will all be tax-free at that point.
Plus, you can withdraw your initial investment at any point without any penalty. So, if you invest $5,500 per year for the next 10 years, and that investment increases to $120,000 during that time, you can withdraw the entirety of your $55,000 investment without penalties.
There are income limits for a Roth IRA. As of 2015, if you want to contribute to a Roth IRA without restrictions, you can make up to $116,000 as a single person or $183,000 as a married couple. Contributions begin to phase out between $116,001 and $131,000 as a single person and $183,001 and $193,000 as a married couple.6 Above these income levels, you can’t contribute to a Roth IRA. Of course, you can still contribute to a traditional IRA.
Which IRA Should You Choose?
Provided that your income is below the maximum Roth limits detailed above, you may have difficulty deciding which type of IRA to contribute to. It might help to think of it as basically making a bet on whether you think taxes will go up or down for you in the future.
If you think they will go down, you should probably choose the traditional IRA, as you won’t be paying taxes now, and you’ll be paying lower taxes in the future when you do withdraw.
If you think taxes will go up, you should probably choose the Roth IRA. You’ll be paying taxes now, but you won’t have to pay taxes in the future when they are higher.
How do you know if taxes will go up or down in the future? Well, you really don’t. But taxes are pretty low right now from a historic perspective. I don’t know how much longer we can keep them this low if we want to thrive as a country. So, I invested in a Roth IRA. I also really like that I can withdraw my initial contributions without a penalty.
The U.S. tax code is complex. There are some other types of retirement accounts that we haven’t covered today. These include Roth 401(k)s, Thrift Savings Accounts, and 403(b)s. I think they’re outside the scope of today’s post, but maybe we’ll cover them in a future post.
You may be asking yourself whether to invest in a 401(k) or an IRA if you only have a certain amount to invest in retirement. If your employer offers a 401(k) with a match, I would advise investing in your 401(k) up to the match. After all, that’s free money and provides you with an instant return on your money. That’s not something you should throw away.
After investing your 401(k) up to the match, I would recommend investing in an IRA up to the maximum contribution of $5,500 per year ($6,500 if you are 50 or older). The reason for this is that IRAs that you manage yourself offer you a lot more flexibility than 401(k)s, and in many cases you’ll be able to make more optimal investments with lower fees.
Then, if you have any money leftover, invest that in your 401(k).
There are some great benefits to investing in these retirement vehicles beyond just tax benefits. For example, your retirement accounts are protected in the case of bankruptcy. So if you have a medical emergency that drains your savings account and puts you in debt to the point that you need to declare bankruptcy, you won’t lose your retirement investments.
Additionally the amount of money you have in your retirement accounts is not counted as part of your assets if you have a child applying for financial aid at college or university.