We’re getting closer and closer to opening a retirement account. Now, it’s time to review the types of accounts. Although I gave a quick overview in my Investing Terms to Know section, we’re going to get into the nitty gritty of these different retirement accounts and ways to invest within each one. I’ll go over what I know, and I’ll provide links to people who know a lot more than me if you want to explore even more. In the words of Marvin Gaye, “let’s get it on.”
401K
A 401K is an employer* sponsored retirement plan. Often provided as a benefit in salaried positions, a 401K allows employees to automatically contribute a portion of their salary to their retirement. These contributions have tax-advantages. In a Traditional 401K, employee contributions are made BEFORE taxes are taken out. The money is taxed as the money is taken out and used in retirement. In a Roth 401K, employee contributions are made AFTER taxes are taken out. That means when the money is used in retirement it will not be taxed.
A 401K may also have the advantage of an employer match. For the contributions you make, your employer would match that (often to a certain percentage). If you DON’T contribute, you’re could be missing out on this money.
Like most retirement accounts, money in a 401K could face a penalty tax if taken out before age 59½. There are special considerations like paying for a home, tuition, or specific medical expenses, but for the most part, if it’s not absolutely necessary to take money out of the account, you shouldn’t. On the other end, there are Required Minimum Distributions. This is a certain percentage of your account that must be taken out each year after the age of 75.
TL;dr Pros and Cons
Pros | Cons |
Included in your job benefits | “Tied” to your employer, if you left the company, you’d have to go through the process of rolling over |
Employer can offer matches | Not really a con, but can take months to years for your employer match to be vested |
Narrows down choices for you | Your options can be limited based on what your employer offers |
Can contribute up to $19,500 (in 2020) | Withdrawal penalties can occur if money is taken out before 59½ |
403b/457b
I’ve put these together because they operate similarly. Both are similar to a 401K, but they are geared towards those in public service and government positions. Because of this, there’s less likely to be an employer match but there are some other benefits that can be included in your 403b/457b. Here’s a podcast that goes so in depth you may come out scared: Millionaire Educator shares the Secrets of the 457b.
If you’re like me you may be wondering why there even needs to be a 403b or 457b when the 401k exists. The reason lies in who these accounts serve. Because the 403b/457b are for non-profit organizations, they aren’t subject to some of the same costs as a 401k. Truly, the more you know.
IRA
An IRA is an individual retirement account. These are perfect if you’re a strong independent woman (like me), or really for anyone at all. IRAs are also tax-advantaged, with both traditional (tax comes out when money is disbursed) and Roth (tax comes out when it’s put into the account). IRAs have their own maximum contribution per year. In 2020, that is $6,000 for individuals under 50, and $7,000 if you’re over 50. This is COMBINED. If you’re 22, and you put $6,000 in your Trad IRA, you can put $0 in your Roth. If you put $3,000 in your Trad IRA, you can also put $3,000 in your Roth! Get it? Great.
The biggest difference between these accounts is the tax-advantage, so when deciding which account to get, you have to consider how the different tax options can work for you. A nice tip I’ve heard is to think about your current and expected income. If you think you’ll be making more money when you retire than you do in the present, it would be more effective to have a Roth IRA because you pay taxes at your current presumably lower tax bracket. If you think you’re making more now than you will in retirement, paying taxes as you withdraw money may be a better bet.
It can be a good choice to have both an IRA and your employer sponsored option. If your IRA is already open it ca be simpler to rollover retirement funds when changing jobs. There’s also a lot more choice with an IRA.
That’s it for this week. Here’s a great next step: decide what type of IRA would be right for you. Think about what salary you’re making, how much you’re willing to save, and what’s easiest for you in your situation. When it comes down to it, you know what’s best for you!
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