Are You IRA? Yup, I’m 401(k)
We’ve talked about why you should already be saving for retirement, now let’s talk about the most common ways to do so: Individual Retirement Accounts (IRAs) and 401(k)’s (so much jargon, I know!) These accounts are great ways to lock down your retirement savings and save $$ on taxes. There’s a lot to say about the U.S. tax code (and there will be future articles about taxes), but we’ll focus on giving you just enough to understand these accounts and start using them to help you retire in style 🌴
Did you know that the average 401(k) balance for 20–29-year-olds is $11,800? A 401(k) is a plan that allows employers to help employees save for retirement while getting a tax break! 401(k)’s are essentially employer-managed investment accounts with some neat incentives:
Employer-based contributions: This means that your employer contributes to your 401(k) by automatically taking the money out of your paycheck. The big plus is that you don’t even have to think about saving your money/choosing an account, because your employer takes care of that for you. Also, most companies offer 401(k) matching, which is essentially free money 🤑! That is, if your company has a match of $5000, then if you contribute $5000 from your paycheck, you’ll land $10,000 into your 401(k) account! Win win! 💸
Tax Break: 401(k) contributions are pre-tax, which means you do not have to pay taxes on them when you add the money to your account. For example, if you contributed the maximum $19,500 to your 401(k), that $19.5K is tax-free! HOWEVER, once you start withdrawing from your 401(k) in retirement, you will have to pay taxes on those withdrawals. HOWEVER HOWEVER, you won’t have to pay separate taxes on the amount of money you make in your account between now and retirement (i.e. capital gains).
If you aren’t employed, your employer doesn’t offer a 401(k), or want to contribute over the $19.5K limit (like a personal finance wizard), not to worry! Individual Retirement Accounts (IRAs) to the rescue 🧙IRAs come in 2 flavors: Traditional and Roth.
Traditional IRA’s are like mini-401(k)’s: you get to waive your contributions, deferring your taxes until you eventually withdraw from your account! The big difference is how much (or whether) you can waive your contributions. Basically, if you make over a certain amount, you can’t make those contributions disappear from your taxes when you make them 😢 HOWEVER, the money in your account will still grow tax-free, so you will still be better off using it than not. The hefty withdrawal penalties will also make sure your retirement money stays retirement money. 💪
Roth IRA’s are like reverse Traditional IRA’s: you have to pay your taxes when you contribute to your account, but when you take out your money, it’s tax-free. So if you put $3000 into a Roth IRA, you have to pay taxes on those $3000 that same year, but $0 when you actually retire. Roth IRA’s also have a hard limit on how much you can make and still contribute to this account. For 2020, if you make over $139K a year, you can’t contribute to a Roth (I’m just going to leave this here…)
Roth vs. Traditional
IRAs (both Roth and Traditional) have lower contribution limits than 401(k)’s. In 2020, the limit for ALL IRA contributions is $6000.
The big consideration of Roth vs. Traditional? How high do you think your income is going to be in retirement? A good rule of thumb is: the higher your income, the higher your tax burden. Meaning: you’ll save the most in taxes if you pay them when you have the smallest income. If you’ll be living off of the many millions you make from selling bitcoin when you retire, you’ll save more with the Roth. If you want to camp in an RV in Yosemite and live off the land when you retire, you’ll save more with the Traditional.
Action Items 💪
If you’re employed, ask your company about any 401(k) benefits that may be available to you (that’s what HR is there for!) 401(k) plans vary based on who provides it and how convenient it’ll be to contribute. If you don’t work for a company, consider the 401(k) (e.g. matching, convenience, etc.) as a part of the many incentives (e.g. pilates classes) you’re weighing between your potential job offers ⚖️
If you can’t open a 401(k) or want to invest more towards your retirement, look into opening an IRA. You can open an IRA with insert-robo-advisor, and the money you add to that account will get auto-invested for you. If you’re more hands-on, you can open an IRA with insert-brokerage, add money to it, and then choose how that money gets invested. Both options give you the same tax benefits, they just differ in the amount of control you have over your investments/how many fees you pay. We’ll get into more detail about robo-advisors/brokerages in future editions, but suffice to say, if the organization holds people’s money for a living, it probably has an IRA. 🏦
Hopefully, this gives you a sense of the options out there for you to start saving money and taxes for retirement. There’s a lot to be saved if you use these accounts to invest for retirement, and no matter what you choose, starting early is the most important thing 😤
Disclaimer: The content on Young, Not Broke is for informational and educational purposes only and should not be construed as professional financial advice. Should you need such advice, consult a licensed financial or tax advisor.