Understanding all the different retirement accounts is confusing as hell. What’s a 401(k) and how is it different from an IRA? Why is everyone so stoked about a Roth IRA and can I have a traditional IRA and Roth at the same time? Do I need an IRA if I have a 401(k)? HALP! In this post Financial Coach, Clo Bare, explains the basics of employer-backed retirement accounts and IRAs.
Does the acronym “IRA” make you want to bury your head in the sand and go to sleep? Do you have a 401(k) or 403(b) but have no idea if you’re using it correctly? Have you avoided even starting to save for retirement because the process sounds confusing AF and like you need a HUGE amount of time to learn about it and understand how to save for retirement?
I feel ya.
Understanding all the different ins and outs of retirement accounts is super confusing. Even two years ago, I had no idea what a 401(k) was or why I should contribute more than the employer match. I’d never opened an IRA and I certainly didn’t manage my own retirement accounts.
Why it Took Me 29 Years Before I Learned How to Save for Retirement
Why did I wait so long before deciding to actually learn about these tax-advantaged retirement accounts?
Because I accepted that I was “bad with money” and would probably never retire because that sounded easier than figuring out the math and methods of saving for retirement.
But it’s not really my fault, and it’s also really not your fault for not knowing too.
The thing about retirement accounts, the IRS, and investing is that the system BENEFITS from you not understanding how to optimize your money. If you don’t understand how to get tax cuts or make investments that allow you to retire or save the most amount of money possible, you’ll likely keep on spending money without saving as much as you could, and you know what that means?
You have to keep on working.
Retirement doesn’t become an option because you’re “bad with money”. The government benefits from you staying in the workforce and making a taxable income while you spend your golden years working at a grocery store to make ends meet since social security and pensions are a thing of the past.
Not ONLY that, but we don’t learn this stuff in school. This stuff should be REQUIRED learning from the time you’re in elementary school to the time you graduate from college because it’s complex and takes a long ass time to learn.
But, instead, we rely on expensive tax-professionals and certified financial planners to manage our money because *throws hands up in the air* IT’S TOO FUCKING COMPLICATED TO LEARN WHILE ALSO TRYING TO ADULT.
I feel you, my dude. And I'm here to help.
I’m going to cover the three most common retirement accounts in this post: 401(k)s, IRAs and Roth IRAs. There are other options out there for retirement, but this post will cover the basics. In a future post, I’ll cover some other options for retirement.
Before we dive in, let’s take a minute to discuss why you should even give a flying fuck!
Why You Should Care about IRAs, 401(k)s and other Tax-Advantaged Retirement Accounts
Now, I like to focus on the WHY because the why will be what makes you read this post, LEARN and dedicate yourself to understanding this ish.
Why should you care about understanding retirement accounts if there are people out there you can hire to do it for you?
Because it’s your future.
It’s your “when can I stop working someday?”
It’s your money and the way you’ll choose to live for the rest of your life.
Because it’s your option to choose.
It’s freedom to say “no” to that shitty job you don’t want to work at anymore.
And it’s your money, which means it’s your life, your freedom and your options.
Do you really want to put that power into the hands of someone who benefits from you never learning this stuff yourself?
If the answer is yes, do you, boo-boo.
If the answer is no, read on, my dude. Deep breath. You got this. It takes time. Be proud of yourself for beginning, no matter where you’re at right now.
401(k)s, 403(b)s and other Employer-Backed Retirement Accounts
These retirement accounts are through your employer and 401(k)s are typically used for folks working in the private sector while 403(b)s are for folks who work in the public sector. Generally, 401(k)s and 403(b)s are almost identical but there are usually more advantages to a 403(b), including quicker vesting time and the ability to make more catch-up contributions.
For both 401(k)s and 403(b)s, your employer picks the financial institution, the brokerage, and the funds that you can choose from in that investment platform. 401(k)s and 403(b)s are not investments themselves, rather they are tax-advantaged buckets in which you can hold your investments.
What does that mean? Picture it this way. If you had a bucket filled with rocks, the rocks would be the stocks and mutual funds and bonds that make up your retirement portfolio and the bucket would be the 401(k).
The best thing about a 401(k) is that USUALLY your employer has a match when you contribute to your account. Which means…
FREE MONEY– WOO!!!!!
Ok, not free.
You still have to have a job to earn the employer match on these bad boys, but these accounts are great because generally, your employer provides a match up to a certain percentage or dollar amount.
THAT IS FREE MONEY.
If you don’t get your match, you’re leaving money on the table which is why EVEN if you have credit card debt, you should absolutely be contributing to your 401(k) to get that match.
Don’t leave money on the table.
If your employer matches up to 3%, put in that 3%. That’s a 100% return on your investment! Where else do you get that type of ROI? Nowhere. NOWHERE.
If your employer matches 100% up to 3% and then 50% up to 6%– put in that 6% because again, when else are you even going to get a guaranteed 50% return on your investment.
TELL me. I’ll wait.
401(k) Benefits
Your contributions are pre-tax dollars which will slash your tax-bill because your adjusted gross income (AGI) will be lower. Yay, tax-breaks in the year you contribute AND saving for retirement! Wut-wut.
Contributions come out of your paycheck automatically so you pay yourself first, like your granddaddy always told you to do! The temptation to spend that money is no longer there because it’s already spent on your future. YESH.
Convenient AF. You set your match and you forget about it, other than once or twice a year when you rebalance your portfolio if you’re managing your account yourself (which I recommend, sweetums because if you have your brokerage manage it, it comes with some hefty-ass fees). Learn more about balancing your portfolio in an awesome article from Millennial Revolution. “Balancing your portfolio” means reallocating funds so that you have a nice balance of stocks, bonds, mutual funds, etc. How you balance those depends on your risk preference. For example, I have a high risk preference because I’m still JUST BARELY in my 20s and have a long time before retirement so 80% of my portfolio is stocks and 20% is in bonds.
Your employer picks the brokerage/financial institution. Saves you the headache of choosing for yourself. Upsides and downsides to this.
You can contribute up to $19.5k in 2020 if you’re under 50 which is $13.5k MORE than what you can contribute to an IRA. If you’re over-50 and playing cash up (lol, get it.. Cash up instead of CATCH up. I crack myself up), then you can contribute a whopping $26k a YEAR. WUT.
Some plans allow you to take a loan from your 401(k) if you’re in a pinch. Read about my opinion on doing that in “How to Pay Off Credit Card Debt”. Spoiler alert: in COVID-19 times, I don’t recommend it.
The funds you can choose from were already selected by your employer. Again, convenient but upsides and downsides.
401(k) Drawbacks
- Since it’s pre-tax you will have to pay taxes on it when you retire and your retirement tax bracket might be way higher than what it was when you first started investing.
- If you withdraw fund early (before the age of 59 1/2), you’ll likely be subject to a 10% penalty AND federal and state income taxes. There are exceptions to this and you can read about Hardship Distributions here.
- You MUST take out required minimum distributions (RMDs) once you hit 72 years old. IDK why that’s a downfall, tbh. If I’m 72 with money in the bank, I’ll probably be spending.
- You have fewer investment options than in an IRA because your employer picked the funds. Convenient? Yes. Downfall too? Sure.
- 401(k)s can come with a lot of management and administrative fees that can erode your investment earnings. And unfortunately, providers can hide those fees in sneaky ways so you never really know all the fees your paying. Best way to find out? Call your HR person or the point person for the account.
- Most 401(k) plans have vesting periods which means you don’t get the full amount of the employer match unless you’ve been working for the company for a certain number of years, usually at least five.
- You ALSO pay taxes on your investment gains when you withdraw money in retirement, unlike in a Roth IRA.
Individual Retirement Accounts (IRAs)
The next retirement buckets we’ll cover are the Individual Retirement Accounts aka IRAs which are not tied to your employer. Just like the 401(k) the IRA is not an investment itself, it’s a bucket for the investments you choose.
Also like the name indicates, any individual who is a US resident or citizen can open one of these and contribute $6k a year to an IRA in 2020 or $7k if you’re 50 or older. You can set up an IRA with a bank, financial institution or brokerage to hold either cash, stocks, mutual funds, and bonds specifically for retirement.
While there are 7 types of IRAs, we’ll be talking about the two most commonly used IRAs, a Roth IRA and a Traditional IRA. Both options, your money will grow tax-free or tax-deferred while it’s in the account however whether it’s tax-free or tax-deferred depends on the type of IRA.
Roth IRA
Bitches love the Roth IRA.
Why?
Because you don’t have to pay taxes on your investment gains and you also don’t have to pay taxes when you take that money out of retirement. This is great for a few reasons.
- You foot the bill for taxes upfront. This is good because if you retire in a higher tax bracket than what you did when you contributed to your Roth IRA, you are saving your future self money by paying taxes when you’re in a lower income tax bracket.
- Tax-free gains! Those gains you make in the market too? Those are tax-free because you put post-tax money in it!
But there are even more benefits to Roth IRAs:
Roth IRA Benefits
- Withdrawals in retirement are TAX FREEEEEE.
- You can take your contributions out any time without a penalty and without paying taxes! No other retirement account on this list offers that.
- Investments grow tax-free. Mo’ money in your old lady pockets!
- More investment options than a 401(k) because you pick them, not your employer.
- You’re in full control of how you manage it unless you use a broker.
- Doesn’t have all the high fees of a 401(k). Ca-ching! Unless, again, you use a broker. *cough* don’t *cough*.
- Even if you have a retirement account through your work, you can STILL contribute to a Roth IRA if you qualify, based on your income.
- NO required minimum distributions, meaning you don’t have to start taking money out at the age of 72 if you don’t want to, unlike in traditional IRAs and 401(k)s.
Roth IRA Drawbacks
- Contributions are not deductible from you income, which means you won’t have a lower tax bill the year that you contribute to your Roth IRA.
- There are income limits that phase high-earners out of being allowed to contribute to a Roth IRA. There is a back-door Roth that allows folks who make more than the limit to contribute, and you can check out an article about how to do that here. Income limits, based on your Modified Adjusted Gross Income (MAGI) for 2020 are:
- Single or Married Filing Separately and you Did not Live with Your Spouse at all during the year:
- < $124k, you can contribute the limit
- ≥ $124k but < $139k you can contribute a reduced amount
- ≥ $139k, you cannot contribute to a Roth IRA
- Married Filing Jointly (MFJ):
- < $196,000, up to the limit
- ≥ $196,000 but < $206,000, a reduced amount
- ≥ $206,000, you cannot contribute to a Roth IRA
- Married Filing Separately (and you lived with your spouse at any time during the year):
- < $10k you can contribute a reduced amount
- ≥ $10k you cannot contribute
- Single or Married Filing Separately and you Did not Live with Your Spouse at all during the year:
- Which brings me to another drawback, the Roth IRA contribution limits based on income can be confusing, but contributing to a Roth IRA is still worth it. I promise.
Traditional IRA
For the schmucks that can’t contribute to the Roth IRA, there is also the option of a traditional IRA, which is a little more complicated and less exciting.
Unlike a Roth IRA, you pay taxes when you pull the money out. How much you pay in taxes depends on if you have a deductible or nondeductible IRA.
This is a good move if you think you’ll be in a lower tax bracket than when you are when you’re contributing to the IRA, but there aren’t as many advantages to this account especially because in many cases your contributions are not deductible from your tax bill when you contribute.
With both a deductible and non-deductible IRA, you can start taking the money out of the account when you turn 59.5, and you have to take a required minimum distribution (RMD) when you reach the age of 72.
Deductible vs Nondeductible IRA
The deductible versus non-deductible issue with IRAs is very confusing. Basically, if you or your spouse has an employer-backed retirement account, then whether or not your contributions to your Traditional IRA is deductible from your tax-bill when you contribute depends on how much you make.
Deductible IRA
If you or your spouse are not covered by a retirement plan at work, your contribution to your IRA is completely deductible. That’s a big bonus if you do not have a retirement plan at work AND you’re a high earner because there are no income limits to contribute to an IRA.
If you or your spouse has a retirement plan through work, here are the income limits for a deductible IRA:
Single or head of household
- $65,000 or less, full deduction
- more than $65k but less than $75k, partial deduction
- $75k+, no deduction
Married filing jointly
- $104k or less, full deduction
- more than $04k but less than $124k, partial deduction
- $124k+, no deduction
Married filing separately
- Less than $10k, full deduction
- $10k+, no deduction
To make matters on whether your contribution is deductible or not MORE confusing, the limits above are based on your MODIFIED adjusted gross income (MAGI) which is calculated from a worksheet that the IRS has.
Confusing, right?
It’s a pain in the ass. But it gets worse if you’re for sure making nondeductible contributions which we’ll cover in a moment.
Deductible IRA Benefits
- Lowers your tax-bill the year you contribute. Yay, tax-breaks!
- More investment options than a 401(k).
- You’re in full control of how you manage it unless you use a broker.
- Doesn’t have all the high fees of a 401(k).
- You can use the money to pay for qualified college expenses or up to $10k toward the purchase of your first home. You’ll only have to pay taxes on it, not the 10% penalty.
Deductible IRA Drawbacks
- Unlike a Roth IRA, your investments do not grow tax-free. Less exciting, I know.
- You pay taxes on your withdrawals in retirement, which can be fine if you are in a lower tax bracket than what you were in when you were contributing.
- There are required minimum distributions once you reach the age of 72. Again, I don’t really count this as a drawback.
- If you take out the money before the age of 59.5, you will be taxed at your income level PLUS you will receive a 10% penalty. Yuck. Don’t do it.
Nondeductible IRA
If you do not fulfill the requirements for the deductible IRA, there is also an option to contribute to a non-deductible IRA. Non-deductible IRAs are simple in theory– you cannot deduct the contributions from your tax bill the year that you contribute. Unlike a traditional deductible IRA, you deposit after-tax income.
When you pull money out in retirement, part of your IRA will be taxable and part will be nontaxable. The nontaxable portion is the money you’ve already contributed to the account and have already paid taxes on. The taxable portion is the gains your account has made over the years.
For example, if over the years you contributed $100,000 to a nondeductible IRA and by the age of 72, the account grew to $150k, that $50k would be taxable because it was growth from the investments you made.
Confusing, I know.
Another downside to this is you are responsible for keeping track of your contributions so that in retirement you can ensure you are taxed appropriately. You have to keep track of your contributions with a special form from the IRS which means your bookkeeping skills better be decent.
Annoying, right?
Nondeductible IRA Benefits
- There are no income limits to contribute.
- It’s tax-deferred so you don’t have to pay taxes on your investment gains until retirement.
- You can use the money to pay for qualified college expenses or up to $10k toward the purchase of your first home. You’ll only have to pay taxes on it, not the 10% penalty.
- More investment options than a 401(k).
- You’re in full control of how you manage it unless you use a broker.
- Doesn’t have all the high fees of a 401(k).
Nondeductible IRA Drawbacks
- No significant tax benefits like a deductible IRA or Roth IRA.
- Confusing AF.
- Extra paperwork you have to keep track of yourself. Blech.
- If you take the money out before the age of 59.5, you’ll be taxed on your investment gains AND pay a 10% penalty. Gross.
- You have to take the required minimum distributions starting at the age of 72.
Great. WTF Do I Do with All this Info Now, Clo Bare?
It’s a lot of information, I know. This is why people often resort to hiring a certified financial planner (CFP) to manage this crap for them, even though CFPs can cost you quite a bit in your retirement because they take a commission from your portfolio.
I can’t tell you exactly what to do, but generally, 9 out of 10 times, the Roth IRA is a great place to begin in addition to getting that employer match in your employer-backed retirement account.
The goal, in my humble opinion is to max out both (ie $6k in your Roth IRA and $19.5k in your 401(k) every year). After that? You can start looking into other investment vehicles for retirement.
As for Deductible and Nondeductible Traditional IRAs?
I think they are great options if no other options exist for you. If you don’t qualify for a Roth IRA, saving a little bit more for retirement is still saving more for retirement! Do you get all the benefits of a Roth? No. But do you get some benefits by using it? Definitely if it’s deductible and a little bit if it’s nondeductible.
If using one of these vehicles makes you save more money for retirement, then I am ALL for it.
Need a little extra guidance?
Hit me up in the comments, drop into my DMs on Instagram or head on over to my Financial Coaching page to book a free 15 minute call to learn more about this stuff.
I’m always available to hire as a financial coach to help you navigate these things and I offer lots of free resources on my Instagram and YouTube channel if that’s more your jam. Check me out, follow, hit subscribe, and I promise, if you WANT to learn about this stuff, it’s possible, and you will.
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