When I landed my first job out of college, I didn’t know much about retirement investing. I’ve heard about 401(k)s and IRAs, but to be honest they just sounded like something people in their 40s should worry about (spoiler alert: it’s actually something you need to worry about right now). I knew it was probably important, but didn’t know quite enough to know why.
According to data from Fidelity, you most likely are in the same boat (if you aren’t, good for you!). Only about 7-8% of people in their 20s and 30s contribute to their 401(k)s and only 25% of American adults have any retirement savings at all. That’s an insanely low number!
Well, here’s why it’s important to know about these things and take action now: compounding interest. When it comes to personal finance, compounding interest basically refers to your investment growing exponentially over time. If you like money, you definitely want to pay attention to this.
Just a little bit of money invested now can add up to huge sums by the time you retire. You really don’t want to miss out on those gains because you waited until it was too late. $25,000 invested in your 20s could turn into $1,131,481.38 by the time you retire (investment*growth_rate^years_invested = 1,000*1.10^40. Thanks high school math). That’s a lot of money! Best of all, you didn’t even have to do anything to get those gains besides set aside a little money in your 20s.
To show you how you can take advantage of compounding interest, here’s everything you need to know about the two main retirement accounts: the 401(k) and an IRA. These two accounts are the main ways to invest for retirement while getting the best tax advantages.
Special thanks to Jenny for writing this one.
The 401(k) Explained
What’s a 401(k)?
A 401(k) is a retirement savings account offered by employers to its employees. The name is just the code the Internal Revenue Service (IRS) uses to define this plan (nothing too interesting). When you choose to invest in a 401(k), a portion of your paycheck is deducted and deposited into the plan automatically.
It is the employers’ responsibility to run the plan, including deciding who is eligible, how much and when they can contribute, how much the employer will contribute, what investment options to have, how often you can reallocate your investment assets, and what features the plan will have (will loans be allowed, will hardship withdrawals be allowed, etc.). It is your responsibility to decide if you want to participate in the 401k, and if so, how much you will contribute each pay period.
Why Would I Invest in a 401(k)?
The short answer: on top of growing in value over time, investing in a 401(k) also gives tax benefits and may also benefit from an employer contribution.
You could choose to invest your money elsewhere and earn a decent return. The downside is you can only invest the income you have left after taxes. On top of that, you also pay more taxes on any gains you made in those investments. That’s all money that could have been reinvested for even greater returns but is now getting pocketed by the government. Grrr!
On the other hand, you can contribute to a 401(k) tax free and pay taxes later (or vice versa). In this case, the tax money that gets saved is now being used to grow your investments. It also reduces your taxable income leading to even greater tax savings. This leads to a difference of thousands of dollars by the time you hit retirement.
On top of tax savings, your employer can also make contributions to your 401(k) as a percentage of your contributions. This is literally getting free money.
Traditional vs. Roth 401(k)
There are 2 types of 401(k) contributions you can make: Roth and pre-tax. The basic difference between a traditional and a Roth 401(k) is when you pay the taxes.
Traditional: You contribute to the account out of your income before your income is taxed, so that your taxable income becomes lower. But by the time you withdraw, you’ll have to pay taxes based on your current tax rate at retirement. This is the traditional 401(k) plan offered by most employers.
For example, if you earn $1,000 each pay period and elect to defer 5% of your pay, $50 is taken out of your pay and placed in the 401k plan. Instead of being taxed on the full $1,000 per pay period, you are only taxed on $950 ($1,000 – $50 = $950). You don’t owe income taxes on the money contributed until you withdraw it from the plan.
Roth: You pay taxes as you normally would, then you contribute what’s left after taxes to the account. The benefit is you don’t need to pay any taxes by the time you withdraw. Any employer match in your Roth 401(k) will still be taxable in retirement, but the money you put in and its growth is tax-free.
Employer Match
Besides tax benefits, employer match is another perk about the 401(k) plan. This is something most companies offer as a benefit to their employees.
Employer 401(k) matching means your employer contributes a certain amount to your retirement savings plan based on the amount of your own contribution. Typically, employers match a percentage of employee contributions, up to a certain portion of the total salary. It’s basically free money, so at the very least, you should try to contribute enough to maximize the employer match. Most of the time, you will have to intentionally modify your contribution settings to get the full match.
Contribution Limits
You cannot put in as much money as you want into your 401(k) accounts. The government sets a limit on the maximum annual contributions so that those with very high incomes don’t receive disproportionate tax benefits from these retirement plans compared to those with lower incomes.
For 2020, the 401(k) contribution limit is $19,500. This contribution limit applies to any 401(k) contributions, whether a Roth 401(k) or a traditional 401(k). If you’re contributing to both, the combined total of your contributions can’t exceed this amount. If you’re 50 or above, the contribution limit increases to $26,000.
Should You Choose a Traditional or Roth Plan?
With more and more employers now offering a Roth as well as traditional 401(k), a lot of people might be wondering which one to choose. To find the right answer for you, you need to decide between paying taxes now or paying taxes in retirement.
If you believe your tax rate will be significantly higher in retirement than it is now, a Roth account would make sense since qualified withdrawals are tax-free; If you believe it will be significantly lower, a traditional account would be more appropriate since you will pay a lower tax on your withdrawals.
This is why most people, especially young people, lean towards a Roth account. A lot of people predict they will earn more in retirement than they are now and will be in a higher tax bracket.
Your Retirement Income Will Affect Your Retirement Tax Rates
On the other hand, you might also need less income to maintain a similar lifestyle once you retire. You will probably no longer need to set money aside for things like retirement savings and paying for your kid’s college. You may also decide to move to a lower tax state.
Even if you’re closer to retirement, a Roth 401(k) can still be a good option. Even if you end up in a lower income tax bracket when you retire, withdrawals from your traditional 401(k) counts as income. These withdrawals count as income that could potentially put you in a higher tax bracket if you’re still earning a working wage, meaning more taxes and less spending money.
If you’re still unsure, your employer might allow you to contribute to both types of accounts. You might be able to decide year-by-year where you want to make your contributions. You could even split your contributions between the two types of accounts. Financial planners call this tax diversification. This way, you can enjoy the benefits of both, and have more flexibility managing your taxes at retirement.
How much should I contribute?
The general suggestion is to save at least 15% of your pre-tax income for retirement. That’s assuming you save for retirement from age 25 to age 67. Together with other steps, that should help ensure you have enough income to maintain your current lifestyle in retirement. Fidelity has a great breakdown that explains why 15% is a good rule of thumb.
As you might expect, this number also depends on your other personal targets and lifestyle. If you’re aiming for a later retirement, you could lower that number a bit. If you want to retire early, you should up that number a bit. If you still have student loans to pay off, you should prioritize paying that off as soon as possible rather than investing in retirement. I still recommend, at minimum, to contribute enough to get your employer’s full contribution match.
Withdrawal Options
A 401k is a retirement plan, not a savings account. Money placed in a 401k is not easy to access in an emergency. If you are under age 59.5, in most cases, you will incur a 10% early withdrawal penalty and have to pay taxes on the amount taken, so it should only be used as a last resort. Some plans allow loans and hardship withdrawals without the penalty (still subject to taxes), but the qualifications are strict.
With a traditional 401(k), you can start receiving distributions at age 59.5. With a Roth 401(k), you can start withdrawing money at the same age, but you also must have held the account for at least five years.
The rules for accessing your money are determined by your employer’s plan. Most 401(k) plans allow retired participants to withdraw money in regularly scheduled installments or take partial withdrawals whenever they want. See the IRS for some general guides.
You can also choose to let your money sit in the account and keep growing. But there is a minimum distribution required once you turn 72.
What Happens When You Leave Your Job?
If you’re leaving a job, you usually have three choices:
- Leave it be. If you have more than $5,000 invested in your 401(k), most plans allow you to leave it where it is after you leave your job. This isn’t ideal: You’ll no longer have the company’s help with your questions, and you may be charged higher 401(k) fees as an ex-employee. But if you have a substantial amount saved and like your plan portfolio, it may be a good idea.
- Roll it over. This is the most common choice. If you switch to a new job and your new employer offers a 401(k) plan you can participate in, you can rollover your money into the new plan. It’s a good choice if you like your new employer’s plan. Alternatively, you can roll your money into an IRA, which will be explained in the next section. An IRA has certain advantages over a 401(k), which makes this option usually more desirable.
- Cash out. This is almost certainly your worst option. Don’t do this! It would sabotage your retirement, and also comes with some brutal penalties and taxes levied by the IRS.
The IRA Explained
What’s an IRA?
Unfortunately, not all employers offer access to a 401(k) plan, especially small businesses. However, you can still reap the same tax benefits with an IRA (individual retirement account).
Both a 401(k) and IRA help you save for retirement and offer tax benefits. The main difference is, employers offer 401(k)s, while IRA accounts are opened by individuals. Typically you would go to a broker or a bank to open an IRA.
Traditional vs. Roth IRA
Similar to 401(k), the two main types of IRA are traditional IRA and Roth IRA, and they work in the same way as the corresponding 401(k) plan as to how they are taxed. A traditional IRA means you make tax-free contributions now but pay taxes later while a Roth IRA means you pay taxes now but don’t pay taxes later.
The same benefits of a Roth 401(k) over a traditional 401(k) also apply here. A Roth IRA may be more favorable if you predict your taxes in retirement will be higher than they are now.
Contribution Limits
Just like a 401(k), there are some contribution limits for IRAs you should be aware of. Compared to the limits of a 401(k), the contribution limits of IRAs are lower. For 2020, your total contributions to all of your traditional and Roth IRAs cannot be more than $6,000 ($7,000 if you’re 50 or older).
You can contribute to a traditional IRA regardless of how much money you earn. However, you’re not eligible to open or contribute to a Roth IRA if you make too much money. For the detailed limits, check the IRS website. If you have a high income, but still want to contribute to a Roth IRA, you can look into something called a backdoor IRA. A backdoor IRA allows you to contribute to a Roth IRA indirectly using a tax loophole. You can learn more about that here.
Choosing a 401(k) vs. an IRA
The two plans are similar in how they work, yet they differ a lot in many details including eligibility, contribution and withdrawal rules.
Here are the main advantages of each:
- IRA: You have more options to choose from in terms of the type of investments you want. This gives you much more control over your investment options and lets you tailor your investments to your particular situation.
- 401(k): The biggest benefit of a 401(k) is your employer’s match. There’s not much out there that beats free money. On top of that, a 401(k) has a higher contribution limit. So you can be more aggressive with how much money you’re putting aside for retirement.
There are a lot of factors that you need to consider when deciding how to start with 401(k) and/or IRA plans, like your income, company 401(k) plans, marital status, age, etc. You may want to consult a financial or tax advisor to determine the best savings options to help you reach your tax and retirement income goals.
However, here are some general guidelines: If your employer offers a 401(k) plan with a company match, try to put enough money in it to get the maximum match. Then, contribute as much as you can to an IRA plan.
After that, you can revisit your 401(k) and contribute more. If you don’t have a company match, you might as well start out with an IRA so you have more investment options to choose from. Another general suggestion is to split your contribution between a traditional and Roth account to get benefits of both.
Conclusion
Long story short, a 401(k) and IRA are retirement investment accounts that let you invest while taking advantage of tax benefits. A 401(k) is best if your employer matches some of your contributions while an IRA is best if not. Choose a traditional retirement account if you think your taxes will be lower when you retire or a Roth account if not (or both if you’re unsure).
If there’s one thing I want you to walk away with, it’s this: invest early to take advantage of compounding growth.
If there’s one action I want you to do (if you aren’t doing this already) it’s this: modify your 401(k) contribution amounts to contribute at least the minimum needed to get your employer’s full contribution match. Do this now!
Also, check out some of these other related articles I’ve written:
- Stock market Investing for Beginners
- 200+ Passive Income Ideas from the Top 10 Pages of Google
- 26 Best Sides Hustles to Payoff Debt
- 10 Easy Ways to Invest with Little Money
Fun facts: I came up with the name PoketheJoe because I like poking him. I'm also smarter than Joe (but he doesn't think so).
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