Here it is, the big bertha. Saving for retirement is the topic I get asked about most, and for good reason. Most of us know that it’s important to save for retirement, but it can be extremely overwhelming getting started.
I’m going to attempt to break down the basics as clearly as possible.
A few quick definitions:
Contributions – Any money that you, or your company, put into your retirement vehicle
Investment earnings – the additional money, or return, that your contributions make until you withdraw (in other words, the ending balance less the contributions)
There is a slight, but, distinct difference between these two – it’ll be helpful to note which is used below.
Types of Retirement Accounts:
The most common retirement vehicles are the IRA and the 401(k).
Pretty awful names. IRA stands for Individual Retirement Account and 401(k) refers to a specific section of the tax code.
The main differences between the IRA and 401(k) are the “sponsorship” and contribution limits of the vehicles.
Note that there are variations of the 401(k) that include, but are not limited to, the 403(b), a similar account offered to educators and nonprofit workers, and 457(b) plans, which are offered to government employees. Also note that there are variations of the IRA that include, but are not limited to, the SIMPLE IRA, a similar account offered to employees of firms with less than 100 employees, and SEP IRA plans, which are typically used by self-employed individuals. I’ll only discuss the Traditional/Roth 401(k) and IRA.
Sponsorship:
401(k)’s are typically sponsored by employers and IRA’s are sponsored by the individual. Put more simply, 401(k)’s are set up by an employer and IRA’s are set up by the individual.
The benefit of an employer sponsored plan is that often companies offer a company match or profit sharing initiative, where the company contributes money to the employee’s 401(k).
For example, a company might offer a 3% match. That means that if you, as an employee, contribute at least 3% of your salary to a 401(k), your employer will also contribute to your 401(k) at an amount equal to 3% of your salary. This is a benefit in addition to your salary. If your employer offers something like this and you are not taking advantage of it, you are leaving money on the table.
Contribution Limits:
The other main difference between the IRA and 401(k) is the contribution limit set by the IRS. These contribution limits typically change every year.
In 2020, an individual can contribute up to $6,000/yr. to an IRA, (for Roth IRA’s, it’s even less if your income is above $122,000). The contribution limit on a 401(k) is $19,500/yr.
Roth vs Traditional Retirement Vehicles:
To make things a bit more complicated, 401(k)’s and IRA’s can further be classified as either Roth or Traditional. The most significant difference between Roth and Traditional retirement vehicles is the tax treatment of contributions and investment earnings.
Contributions made to Roth retirement vehicles are made with after tax earnings, whereas, contributions made to Traditional retirement vehicles are made with before tax earnings. As Traditional contributions are not taxed when they are invested, the contributions, are taxed when they are withdrawn at retirement. Contributions to Roth accounts are taxed when invested but the contributions, are not taxed when they are withdrawn.
Example: Mary would like to contribute $19,000 to her 401(k). Assume her tax rate is 22%. If she invested in a Traditional 401(k), she would put aside $19,000 of her pre-tax dollars today. If she instead invested in a Roth 401(k), she would put aside $19,000 of her after-tax dollars today, the equivalent of $24,359 pre-tax dollars. When Mary retires at 59.5, let’s assume her tax rate is 30%. If she invested in a Traditional 401(k), she would pay $5,700 in taxes at retirement. If she invested in a Roth 401(k), she would withdraw her funds without paying taxes as she already paid $5,359 when she initially contributed the funds.
To decide whether the Roth or Traditional IRA or 401(k) is right for you, I’d start with determining whether you think your tax rate will be higher or lower in the future. If you can make that determination, you can theoretically choose the type of account that will give you the biggest tax savings. If you expect your tax rate to be higher in retirement, choose a Roth account and its delayed tax benefit (see Mary’s example above). If you expect lower rates in retirement, choose a traditional account and its upfront tax advantage.
That’s a pretty high level overview to help get you started.
TL;DR – If your employer offers a 401(k) match that you are not taking advantage of, that is your first and most necessary step. If Traditional and Roth plans are offered by your employer, you’ll have to decide which is right for you. However, taking advantage of the match now is the most important part. You can always change your future contributions between Roth and Traditional as circumstances change.
