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What Kind of Retirement Fund Do I Need?

Settling the Confusion Between 401(k), IRA, and Roth IRA Accounts — Once and For All


Image Source: StockSnap / Oliver Klein
Amanda Holden is a personal finance expert providing hilarious and practical financial advice on her site, The Dumpster Dog Blog.

If you're thinking about retirement, good for you! Retirement is easily everyone's least favorite financial priority but it's also one of the most important. Between rising medical costs, spoiling grandchildren, and traveling the world on a Harley Davidson, living for 30+ years with no job is pretty expensive stuff.

So then the question becomes, how does one save for retirement? And where? In what account? Do we bury some shekels in the backyard? Stockpile our Taylor Swift memorabilia and collectors' items?! Nah, it's easy! Use an account specially designed to hold retirement money like a 401(k) or Roth IRA.

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Even if you're already using a retirement account, now is the time to sincerely understand how they are different (and similar), why we use them, and feel confident you've chosen the right one.

First, how are retirement accounts different than regular ol' savings accounts?

For retirement, you won't want to save money in your regular ol' checking or saving account at Bank of America or Wells Fargo. Why? There are three characteristics shared by all retirement account types that make them turbo-charged — basically the Serena/Simone Biles of bank accounts:

  1. Tax benefits! More on this below.
  2. With these tax benefits do come rules. In the case of retirement accounts, you are spankeroo-d with a 10 percent penalty if you take the money out before age 59 1/2 (there are exceptions to this).
    While this feature may seem limiting, it's actually a godsend! A casual dip into an easily-accessed savings account is far too seductive. Think of all the temptation you'll encounter on the road to retirement — a wedding (or two), new furniture for the house, driving past Panda Express on your way home every day. Having an account specifically designated and designed for retirement is a good thing.
  3. Within retirement accounts, you can invest the money. This is important. Saving your money is only half the battle — you have to invest it as well!

Let's talk about taxes.

Now, obviously no one likes to talk about taxes, but it's the most important part! If you truly want to understand retirement accounts you have no choice but to choke down this financial brussels sprout.

Saved and invested money is taxed in two ways. The first of those is through capital gains tax. That's the tax you pay when you earn money off of an investment, like a stock. This is (mostly) always the case unless you invest the money in a retirement account!

Being free from capital gains tax is easily the greatest and most underrated feature that all retirement accounts share, and you'll reap this benefit no matter which type you choose. If you're doin' it right, the majority of the money you'll end up with in retirement will come from investing — not saving! That makes this one helluva deal.

The second tax consideration is income taxes. Here's where retirement account identities begin to diverge. And the million-dollar question with income taxes is:

Should I pay income taxes now or later?

  • Later:
    The "traditional" forms of retirement accounts — 401(k), IRA, and SEP IRA — are all tax-deferred. This means income taxes are — exactly as it sounds — deferred until later. Instead of paying income taxes up front on the money you earn, you pay taxes on the money you take from your account to spend.

    Income taxes are levied on any money that leaves the account — on what are called distributions.

  • Now:
    Roth IRA and Roth 401(k) are the opposite. Money deposited into a Roth is post-tax dollars. You've already paid income taxes — they came out of your paycheck! — and that's it. Money is not taxed again when you take it out of the account. In this way, it's like your regular ol' checking/savings account.

    Income taxes are taken before money enters the account — on what are called contributions.

So, whether you pay income taxes now or later, it has to happen eventually. Perhaps you are thinking, well then what's the big whoop? Pay 'em now or pay 'em later, who gives a sh*t?

Generally speaking, we should want to pay as little in taxes as possible. And the less we earn, the less we pay in income taxes. So it's best to pay income taxes when we're on the low end of the income scale. Traditional IRA-style accounts were designed for workers to save while they are substantially earning and in a higher tax bracket. For someone like this, it's smart to defer taxes because you will likely be in a much lower tax bracket in retirement (remember, you will pay taxes on distributions — what you spend).

Conversely, if you're just getting started in your career and getting paid in peanuts, but aspire to an extravagant retired life that's something betwixt Queen Elizabeth and Baddie Winkle, a Roth might make more sense. Get those pesky income taxes out da way, and never pay taxes again.

(Disclaimer: Don't lose sleep over this income tax stuff. It's important, but we also can't foretell the future of tax laws so much of this is merely hypothetical. Consult a tax adviser for more questions.)


Image Source: StockSnap / Benjamin Child

What else should I consider when choosing a retirement account?

Income taxes are the biggun'. But as important as taxes are, I want my recommendation to be very clear: Use whatever account is easiest for you. If there's an account you can access through your employer, hit it hard and don't look back. The most important thing is having one you actually use!

This is especially the case if your employer offers an employer match — where your work gives you free money if you make contributions into your retirement account.

(Example: Your employer offers a match of 50 percent of your contributions, up to 6 percent of your salary. So if you contribute 6 percent of your salary towards retirement, they'll match it with 3 percent of your salary.)

For those of you who don't have an account through work — or who simply want to know more! — read on for a comparison of account types. The major considerations you should be a-peepin' in addition to taxation are contribution limits and income limits. Find one that is the best fit for you!

Account Types

401(k)

  • What it is: Retirement account offered to employees of a corporation.
  • Where: At a bank of your employer's choosing.
  • Income Taxes: Later.
  • Contribution Limit (how much you can put into account in one year): $18,000 in 2017.
  • Pros: Money is taken automatically from your paycheck as a percentage of salary (this is a good thing). Lower taxable income for the year. Some companies offer a company match — this match is not included in your $18,000 contribution maximum (can go over this amount with employer match).
  • Best for: Someone who works for a company that offers one, especially if they provide a match!
  • Watch out for: Fees. If you see suspicious fees in your 401(k), talk to your HR department or the bank.

IRA (Traditional IRA and Rollover IRA are the same things)

  • What it is: An individual retirement account that you open and fund yourself.
  • Where: At a brokerage bank of your choosing.
  • Income Taxes: Later. Same tax status as a 401(k).
  • Contribution Limit: $5,500 in 2017.
  • Pros: Lower tax bill for the year. Because you are funding an IRA with money from your paycheck, which has already been taxed, those taxes are refunded upon tax filing.
  • Best for: People without a retirement account offered through their work. Those who want to lower their taxable income for the year. And great to have for consolidating old 401(k) accounts into!
  • Watch out for: You may not be able to deduct IRA contributions if you are already covered by a retirement account through your work and earn more (according to your modified gross adjusted income) than $71,000 (phase out beginning at $61,000).

Roth IRA

  • What it is: An individual retirement account that you open and fund yourself.
  • Where: At a brokerage bank of your choosing.
  • Income Taxes: Now.
  • Contribution Limit: $5,500 in 2017.
  • Pros: Pay taxes now and never again.
  • Best for: Young people or people with low incomes. People without a retirement account offered through work. Anyone who wants to pay income tax now. Freelancers, self-employed.
  • Watch out for: To contribute to a Roth, you must have an earned income (a job). The Roth option was designed for lower earners, so your ability to contribute to a Roth IRA phases out when your income (modified adjusted gross income, specifically) reaches $118,000, up to $133,000 when you can no longer contribute. As a joint filer, these figures are $186,000 up to $196,000.

Roth 401(k)

  • What it is: Retirement account offered to employees of a corporation. It is a newer* hybrid of the 401(k) (employers offer it, may include a match) and a Roth IRA (pay taxes up front).
    *Because the account type is still pretty new, it is not widely offered by employers.
  • Where: At a bank of your employer's choosing.
  • Income Taxes: Now.
  • Contribution Limit: $18,000 in 2017.
  • Pros: Money is taken automatically from paycheck. Some companies offer a company match. Pay taxes up front and never again (although, contributions from your employer may be taxable). Unlike with a Roth IRA, there is no cap on how much money you can earn to use a Roth 401(k).
  • Best for: Someone who works for a company that offers one!
  • Watch out for: If you have both a 401(k) and a Roth 401(k), you cannot exceed the annual $18,000 max between the two — though this does not include any employer match!

403(b)

  • What it is: Retirement account for employees of a tax-exempt organization (teachers, school administrators, doctors, nurses, librarians, some ministers, etc.). It's like a 401(k), but for teachers!
  • Where: A bank of your employer's choosing.
  • Income Taxes: Later.
  • Contribution Limit: $18,000 in 2017.
  • Pros: Savings beyond pension plans. Occasional match programs (though this is rare). Lower taxable income for the year.
  • Best for: Anyone who is offered one!
  • Watch out for: 403(b) accounts come in a couple of different flavors when it comes to investing options. Be careful if you're only offered an annuity (as opposed to mutual funds) — these often have high fees.

Solo 401(k)

  • What it is: Retirement account for people who run their own business and are the only employee (a spouse being the only exception).
  • Where: At a brokerage bank of your choosing.
  • Income Taxes: Later.
  • Contribution Limit: $18,000 from your salary + up to approximately 20-25% of your compensation as a contribution from the business for a combined maximum of $54,000 (the precise calculation depends on how your business is structured).
  • Pros: Much higher contribution limits than IRA and Roth IRAs. Lower personal tax bill this year (through salary deferral — the $18,000) and additional business contributions are potentially tax deductible.
  • Best for: Business owners who are flyin' solo and who earn enough and want to contribute more to retirement than what IRA and Roth IRAs allow.
  • Watch out for: These accounts are more complicated than your run-of-the-mill IRAs, so do your research and get help from a tax adviser.

SEP IRA

  • What it is: Retirement account established by a small business owner or self-employed business for herself (and any employees).
  • Income Taxes: Later.
  • Contribution Limit: Whichever is lower of $54,000 or 25% of compensation (capped at $270,000) per employee.
  • Pros: Much higher contribution limit than IRA and Roth IRAs. Contributions are tax deductible for the business owner.
  • Best for: Self-employed/small biz owner who wishes to contribute to an IRA for herself (and to the IRAs of her employees).
  • Watch out for: Because you are setting up a retirement plan for a business, there's more paperwork, and there are unique rules. Read up on these before proceeding, and always consult a tax adviser.

Note: These descriptions do not include every nuance of every account type. In an effort not to bog you down (which is counterproductive) I have included only what I think is important for someone who is first learning about retirement accounts. For more complete information, Investopedia is a great resource, and the IRS website is actually not that bad. Good luck and happy saving!

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