The 411 on Retirement Accounts
Retirement accounts are one of the most important investment tools to begin using while you are young to grow your wealth. There are several different types of retirement accounts that you can use, and each one has different advantages and disadvantages. Below we will discuss the pros and cons of the different types of retirement accounts, and the ways that you can utilize them to become an old rich bitch.
The first retirement account we’ll discuss, and the one you’re probably most familiar with is a 401K. 401Ks are retirement accounts that are offered by employers to their employees. These accounts are defined contribution accounts, meaning that the employee contributes a percentage of their income to their 401K each time they are paid. If you make $50,000 a year and set your 401K contribution at 5%, you will contribute about $96 to your account every 2 weeks when you get paid.
Employer Match – The biggest pro of a 401K is that you can give yourself a raise just by contributing to it. Welcome to the beauty of the employer match! Many companies will offer to match your 401K contributions up to a certain amount. This is usually written something like this, 50% match up to 5% of your salary. They are saying that for every dollar you contribute to your 401K, up to 5% of your salary, they will contribute an additional $.50. Let’s take a closer look using our previous example. You are contributing 5% or $2,500 of your $50,000 salary each year. The company you work for is also going to contribute 50% of what you’ve contributed, or an additional $1,250! So, your total annual contributions just went from $2,500 to $3,750! Some companies get a little more complicated with this and offer a tiered match. These look something like this. We will match 100% up to 2% and 50% up to 5%. This means that for the first 2% of your contributions, they will give you $1 for each dollar you contribute. For your contributions above 2% up to 5%, they will give you $.50 for every dollar you contribute. Let’s look at some numbers. You contribute $2,500 annually, or 5% of your $50,000 salary. For the first 2% you contribute, or $1,000, your company will match you 100%, amounting to an additional contribution of $1,000. On the remaining 3% that you contribute, or $1,500, they will match 50%, amounting to an additional contribution of $750. In total, they will contribute $1,750 to your account. When added to your $2,500 contribution, you increase your total annual contributions to $4,250! You just gave yourself a raise for trying to help yourself get richer. Who doesn’t love that?!
Tax Advantage – The money you contribute to your 401K is pre-tax. This means that you do not pay any taxes on the money before it goes into your 401K account. This is an advantage because it reduces your taxable income. In the example above, if your salary is $50,000 and you contribute 5%, or $2,500, of your salary to your 401K, you will only pay income tax on $47,500 instead of $50,000. Not only are you saving money you would otherwise be paying in taxes, but you are also contributing more money to your 401K due to this tax advantage. This allows you to benefit more from compound interest. Here is an example. If you contribute 5% of your pretax salary of $50,000, you contribute $2,500. If the 5% you contributed to your 401K was after-tax money and you had a tax rate of 25%, you would only contribute $1,875 to your 401K. That is a difference of $625 each year that you wouldn’t get the benefit of compound interest on!
High Contribution Limit – The 2020 contribution limit for an employee is $19,500. This is the most you are allowed to contribute to your 401K in a single year. 401Ks have extremely high contribution limits when compared with other retirement accounts, as you’ll see later in this post.
Early Withdrawal Penalties – The money you contribute to your 401K can’t be taken out until you reach the age of 59½. 401Ks are tax-deferred accounts, which means that you don’t pay income tax before making your contributions, but instead pay the income taxes when you withdraw the money. If you decide to withdraw money from your 401K early, you will pay the income tax on your withdrawal as well as an additional penalty. The penalties are quite steep at around 10%, and will significantly eat into your earnings. Since these accounts are not very liquid (see this previous post on liquidity), you should always make sure to have other easily accessible money saved to help cover any hardships or unforeseen expenses.
Limited Investment Options – Since your employer selects your 401K plan, you are limited to the investment options from their chosen plan. Your employer dictates which financial services company you use, as well as what funds you can choose from.
Individual Retirement Accounts (IRAs) are retirement accounts that are opened by individuals, not employers. There are two types of IRA accounts, Traditional IRAs and Roth IRAs. For ease, we will refer to Traditional IRAs as IRAs and Roth IRAs as Roth IRAs. Let’s take a look at the pros and cons of each.
Traditional IRAs are more similar to 401Ks than Roth IRAs, so let’s start with them.
Tax Advantage – Like 401Ks, the contributions you make to your IRA are tax-deductible.
More Investment Options – Unlike 401Ks, you will get to choose which financial services company you open your IRA with. Each company charges different fees and offers different services, so you can find the firm that fits your investment needs best. You will also have much broader investment options when compared to the options your company selects for your 401K. This allows you to further diversify from the 401K investment options selected by your employer. (See this post on the benefits of diversifying.)
No Employer Match – The biggest con when comparing IRAs to 401Ks is that there are no employer contributions. If you are offered a 401K match from your company, you should ALWAYS choose to contribute up to their match percentage before you consider opening an IRA. If you don’t, you are leaving money on the table.
Early Withdrawal Penalties – Like 401Ks, there are penalties for early withdrawals from your IRA. Since the money contributed to your IRA is tax-deductible, the penalty is the same as with a 401K, taxes plus about a 10% penalty.
Low Contribution Limit – The contribution limit for IRAs is less than half of 401Ks at $6,000 annually if you’re under 50, and $7,000 annually if you’re over 50.
Tax-Exempt Withdrawals – The biggest advantage of Roth IRAs is, by far, that all of the earnings you make on them are tax-exempt. The main difference between Roth IRAs and other retirement accounts is that the money you contribute is after tax. This means that you have already paid income taxes on it. This is the money in your bank account that you can use to buy anything you want. When you invest your money in a Roth IRA, any earnings from your investments are tax-exempt. So, if you contribute $5,000 and make 10% or $500 on your investments, you will NEVER pay taxes on that $500 you earned. Not even when you withdraw it. Legally earning income without paying taxes is nearly impossible. That is why Roth IRAs’ tax-exempt withdrawals are so incredible.
Penalty-Free Withdrawals – Another huge advantage to Roth IRAs is that you can withdraw any contributions you’ve made penalty-free. If you contribute $5,000, you can withdraw that $5,000 any time you want. No age limit, no taxes since you’ve already paid them, and no penalties. This makes Roth IRAs the most liquid retirement account option. (Again, more on liquidity here.) Any earnings you make on your Roth IRA investments are subject to a 10% penalty if withdrawn before age 59½. This penalty would apply to the $500 you earned on your Roth IRA investments in the previous example. There are some other exemptions to these penalties, but we won’t get into those here.
More Investment Options – Roth IRAs offer all of the same freedoms as IRAs such as choosing who to open your Roth IRA with and the breadth of investment options available.
Low Contribution Limit – Roth IRAs have the same contribution limits as Traditional IRAs, and also have salary caps. If you are single, you can’t contribute to a Roth IRA if you make more than $139K, and if you’re married you can’t contribute if you have a combined salary of over $206K. You can only partially contribute if you are single and make between $124K-139K, and married and making between $196K-206K combined. Roth IRAs should be started as early as possible, so you can contribute as much as you can before you reach the salary cap. Once you reach it, you will have the highest possible amount invested, and be able to take advantage of tax-free compound interest until you reach retirement.
No Employer Match – Same as with Traditional IRAs, you won’t get any free contributions from your employer.
1. Always contribute up to your full employer match to your 401K before contributing to any other retirement account.
2. Roth IRAs are the most liquid retirement account. Once you’re contributing up to your full employer match to your 401K, consider opening a Roth IRA.
3. If you’re self-employed or your employer doesn’t offer a 401K, consider opening a Traditional IRA to take advantage of the tax benefits.
After opening any of these retirement accounts you will need to decide how you want to invest your money and build your portfolio. (Info on building your portfolio can be found here.) Building a diversified portfolio and allowing compound interest to work its magic over time is the key to becoming an old rich bitch with your retirement accounts. Since you already know how to build a diversified portfolio, next week we will discuss the magic that is compound interest.