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Thursday, January 28, 2016

Retirement Accounts 101 (IRAs, 401(k)s, Oh My!)

Have you ever felt confused about all the terminology and acronyms associated with retirement accounts? This post attempts to break it down in an easy-to-understand manner.

Saving for Retirement outside of Retirement accounts

What would happen if we didn't have special retirement accounts, had no pensions, and still wanted to retire? We would simply save or invest in a normal "taxable account". Regular savings accounts and investment accounts are "taxable accounts".  Let's see how these normal accounts are subject to federal income taxes:
  1. Taxes on contributions (initially): The money you put in a taxable account has already been subjected to income tax when you earned it.
  2. Taxes on earnings (annually): The money you earn each year in a taxable account is also subject to tax. A common example is the interest you earn in your savings account. Yes, it may seem small, but even this income should be reported on your tax return. Another example is dividends paid to you for owning a stock or mutual fund, or interest paid by bonds and bond funds in investment accounts.
  3. Taxes on gains (finally): In an investment account, securities (stocks, bonds, or shares of funds) that have increased in value since you bought them are subject to capital gains tax on the difference in price. If you buy some stock for $60, and sell it 2 years later for $100, you owe taxes on the $40 gain in the year you sell them.
As you can see, you are hit with three main types of taxes when saving in a normal taxable account.

The huge benefit of tax-advantaged accounts

Two of the most common tax-advantaged accounts are traditional 401(k)s and traditional IRAs. Both operate identically when it comes to their tax advantage: You get to skip two of the three types of taxes listed above!
  1. Taxes on contributions (NONE): When you contribute to a 401(k) hosted by your job, the money comes out of your paycheck prior to tax deductions. If you contribute to an IRA, you mayget to take a deduction on your tax return for that amount, which is effectively the same as funding it with pre-tax money.
  2. Taxes on earnings (NONE): All earnings, interest, and dividends made within a 401(k) or IRA are completely tax free. This really allows your money to grow unhindered, with the power of compound interest.
  3. Taxes on distributions (finally): Finally, when you take a distribution from your 401(k) or IRA later in life, the money is subject to income taxes.
The main difference between a 401(k) and an IRA is that a 401(k) is employer sponsored. Your job selects the 401(k) management company, and all of your contributions come out of your paycheck. You cannot, for example, write a check from your checking account to add more money to your 401(k). An IRA is an account you open yourself, at a bank or broker of your choosing, and which you fund with your own cash. Anyone can open an IRA, while only those with a company 401(k) plan can contribute to a 401(k).

So what is a Roth account?

 "Roth" is simply an adjective that describes an alternative to the traditional 401(k) or traditional IRA mentioned above. If you have a Roth IRA, or a Roth 401(k), you give up the tax-free contributions (money going in) in exchange for tax-free distributions (money coming out). You still get two out of the three tax savings.

Should I contribute to an IRA if I'm already contributing to my 401(k)?

First, let's visualize the accounts we've discussed so far: 

If you are already contributing to your 401(k) (right side of the image), why would you want to contribute to an IRA (left side of the image)? Here are some potential reasons:
  1. You want investments that will have tax-free distributions in retirement instead tax-free contributions, because you think your tax rate during retirement may be higher than it currently is (because of higher income or tax law changes). Roth 401(k). You open and contribute to a Roth IRA or switch your contributions from pre-tax 401(k) to a Roth 401(k) if your company offers it.
  2. You plan to reach the maximum allowable employee contribution to your 401(k), and still want to save even more in an account that avoids two out of the three types of taxes listed above. In 2016, the annual 401(k) employer contribution limit is $18,000 (for those under age 50), So you open an IRA or Roth IRA
  3. You want access to additional investment options beyond what are available in your 401(k). You can open an IRA or Roth IRA just about anywhere, from low-cost internet brokers, to your local bank, to peer-to-peer lending sites, which have a wide range of investment options, some of which may be better than those offered in your company 401(k)
Whatever you do, make sure you are at least achieving the maximum company match in your 401(k) before you think about opening an IRA.

Notes:
1: There are various contribution restrictions to both deductible traditional IRAs and Roth IRAs, including income limits. Consult IRS documentation for more info.
2: Whenever this article talks about taxes, it's talking specifically about federal income taxes. Other types of taxes (e.g. social security, medicare, state income taxes) my still apply to contributions and distributions from retirement accounts
3. If you work for a government organization, you may have a 403(b) plan instead of a 401(k), but they function the same in most respects.
4. Some companies offer an "after-tax/non-Roth" 401(k) option. I wrote another post about that here!

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