Saving for the future starts with understanding your options today
Roth, Traditional, and 401K -- and why you should start sooner rather than later
The most repeated piece of retirement planning advice is to save early and save often. However, many people might hear 401K and IRA and not know what they mean or where to start. This week we’re breaking down the three most common forms of retirement accounts and outlining the benefits and drawbacks of each.
It may feel not easy to take cash out of your pocket and put it in an account you can’t touch for decades, but there’s a great benefit to these programs that you can’t achieve with traditional savings accounts. That said, you should make sure you feel secure with an emergency fund before you go too deep into retirement planning. Try to save three to six months of bare-bones living expenses before you start pouring cash into retirement. If you’ve got that down, let’s move forward and dissect the differences between the most common retirement savings programs.
Traditional IRA
Anyone can open this account, so long as you have income. Traditional IRAs let you take up to $6,000 (as of 2021) per year — $7,000 if you’re over 50 — and dedicate that money to purchasing stocks, mutual funds, and the like (consult a financial professional for what mix is right for you and how to invest) that you can cash out starting at age 59 and a half. The government requires you to begin taking distributions from an IRA at age 72, regardless of employment status.
The significant benefit of a Traditional IRA is the money you put in is excluded from your taxes the year you invest. That means it can reduce your taxable income by thousands. On the flip side, you will pay taxes on that income when you retire, and you may be at a higher tax bracket by then, depending on your situation. Traditional IRAs have no restrictions on how much income you earn to be able to contribute.
Roth IRA
Roth IRAs are special programs designed for lower-income earners. You cannot contribute to a Roth if you make over $140,000 per year as a single person and $208,000 per year as a couple, and the money you contribute is post-tax, meaning you’ve paid taxes on it already with your traditional income. The investing mechanism and investment amounts are the same as a Traditional IRA. However, all that money grows tax-free and will not be taxed at all upon retirement, meaning whatever is in your account is what you’ll pull out of your account.
Roths are great options when you’re earnings are still low at the start of your career. You can have both Roth and Traditional IRAs in your name throughout your life, so locking into the Roth option at first doesn’t mean you can’t have a Traditional IRA when you’re more established.
What if I have a 401K option through work?
A 401Ks is tied to a workplace and can have more restrictions on what type of investments you make and which financial institution holds your money. They function like Traditional IRAs in that they’re tax-exempt money in the year you invest but will incur taxes upon retirement. However, they have a much higher threshold for how much you can invest per year. In 2021 that limit is $19,500 and up to $26,000 if you’re age 50 and older as catch-up contributions. Thus, it’s much easier to stock away cash quickly in 401Ks. Additionally, many companies offer a match percentage, meaning whatever you contribute up to a dollar amount, they will contribute as a gift above and beyond the $19,500 limit, giving you more significant earning potential.
When you leave a company, you can often continue to house your 401K funds with their accounts as long as those programs exist, or you can roll those funds into your own IRA accounts. If you’re a self-employed person or own a business, 401Ks are still an option. The SEP (Simplified Employee Pension) 401K can be set up for you and your employees, or you can have a Solo 401K as a self-employed person. These options can often allow for higher contribution limits (up to $57,000 per year) but require the help of a tax expert to set up correctly, so I won’t go into the intricacies here as it’s dependant on your situation.
An Important Reminder - You have to actually invest the money!
Often the advice is as simple as “start an IRA,” but while scrolling TikTok, I saw a post that gave me pause. A user who had taken that advice didn’t realize that you had to actively invest the money you have placed into the IRA account or 401K account for it to grow. This step should be something any reputableh program like Vanguard or Fidelity walks you through. Still, it’s always good to check that the company purchases mutual funds, ETFs, or whatever you’ve chosen as your investment vehicle on your selected schedule. I ran into a problem once I activated a rollover from a former company’s 401K resulting in cash entering my account. However, I forgot to purchase any investments, and that money sat for a few months doing nothing. This forgetfulness is a fixable problem, but better to catch and be aware of it as soon as possible.
Bottom Line
In all cases, the most critical factor for growing your retirement savings is compounding interest. That’s why you should start saving as soon as possible, even if the total amount is low. A small amount saved early can be better than a large amount saved later. For example:
Tim puts just $100 a month into his IRA from age 25 and retires at age 65. Jane waits until 35 to start but puts the same $100 a month into her IRA until her retirement at 65. At an 8% rate of return, Tim ends up with more in his account than Jane. While Tim only deposited $12,000 more than Jane into his account, Tim’s final balance is $335,000, while Jane’s is only $146,000. Behold, the magic of compound interest. With that in mind, if you’re ready to start retirement savings, do it now.
Must Read: The Ugly Truth Behind Your Fancy Rewards Credit Card. As someone who touts playing into the points system for your benefit, I think it’s important to know the impact of those points on the overall financial system. Nothing is free, and this article on Vox is an excellent explainer on how the system works and how it can negatively impact low-income households that can’t participate in points cards for various reasons. It also shares some thoughts on reforms that can help everyone, even if points become slightly less lucrative in the long run.
Disclaimer: I am not paid directly to promote any services or products. All advice provided in this newsletter is general advice and does not consider your financial situation. I am not a tax professional.