You know you should think about your retirement plan when you’re young, but what is the difference between a 401k, IRA, and Roth plans?
If you’re like me, perhaps one or both of your parents has been telling you to put aside money for retirement, since, I don’t know, maybe your first day at your first job after college. The conversation usually goes something like:
‘Hey Jonny, how’s your job going so far?’
‘Great Dad, but I mean, it’s only been one day so far.’
‘Glad it’s going well. Hey, have you opted in to your company’s 401k plan? How much are you putting aside for retirement? Are you going to max out an IRA contribution on top of the 401k?’
‘Uhhh, Dad, it’s been one day. I don’t even know when I’m being paid yet.’
Ok, maybe that’s a bit extreme, but you get the idea. For many of us, we’ve heard from our parents, grandparents, or mentors constant reminders about saving for retirement. So why is it so important, and how exactly does it work? IRA’s, Roth IRA’s, 401k’s, pensions…it all seems like a big bowl of alphabet soup. I hope to clarify some of these terms and highlight the differences between them in this article.
Let’s start with the most important thing first – why should you be contributing to your retirement account as soon as possible? You’ve got tons of bills to pay, things are tight financially, why should you prioritize retirement, which isn’t going to happen for perhaps another 30-40 years?
The answer is a key concept to understanding finances and one of the most powerful forces in investing: compounding interest (closely related to time value of money). Essentially, the sooner you start saving money, the quicker and larger it will grow. When you save money for retirement the funds are typically invested in either the stock market, mutual funds, and/or bonds (or frequently a combination of all three). Over time, the stock market historically has always gone up, increasing the value of your investments each year. Additionally, many of the funds your retirement account will be invested in may produce interest and/or dividends, which get reinvested into your savings. The result (hopefully) is that your retirement account is continually reinvesting its earnings and the balance grows and grows, until the point when you’re retired and first start withdrawing those funds.
There are many similar examples to the one you’ll see below, and they all illustrate the same point. Take two people, Saver Bob and Traveler Joe. They are the same age (22) and start working similar paying jobs. Bob listens to his parents’ advice and from day one of his first job takes full advantage of his company’s 401k to put away $10,000 per year, for ten years. Then, at age 32, when family expenses start escalating, he decides to stop contributing and doesn’t touch his retirement account until he’s 65 years old. His buddy, Joe, decides he’d rather spend $10,000 per year in his twenties traveling the world, and he’ll contribute to his retirement later in life. He starts contributing at age 32, and puts the same $10,000 per year into his 401k plan for the next 10 years. At age 42 he stops contributing and doesn’t touch his retirement account until he’s 65 years old. Both Bob and Joe put aside the same $100,000 over a ten-year period of time, but Bob’s money started earning interest and growing ten years sooner then Joe’s. Want to know what the final balances look like when they both retire at age 65?
Joe will have a comfortable $955,000 in his account, while Bob will have $533,000 (for the purpose of this exercise I assumed a fairly typical 6% annual rate of return). Even though they both invested the same $100,000, by starting ten years sooner Joe accumulated $400,000+ more than Bob! Pretty crazy, right?
Also, for what it’s worth, putting aside money early on in your career is a great opportunity, since once you get married and G-d willing start having kids, the family expenses skyrocket and it becomes that much harder to save for the future. Take advantage of the time to put as much money away as possible now if you’re single or just recently married.
Now that you’re motivated to save (hopefully), how do you go about doing that? What are your options?
For starters, you should familiarize yourself with the most basic types of retirement accounts: IRAs and 401k’s. The primary difference between them is that an IRA (Individual Retirement Account) is an account that you own and contribute to personally, completely outside the realm of any employment. A 401k plan, on the other hand, is administered through your employer (although you still own the account). Some employers offer a 401k plan (and great employers will even match part of your contribution), while other employers unfortunately may not offer a 401k. Note that if you’re employed in the non-profit world, you may see the term 403b, which is essentially the non-profit organization’s equivalent of the for-profit company’s 401k.
The other most basic type of retirement account you should become familiar with is a Roth IRA or Roth 401k. The difference between traditional IRA’s and 401k’s and Roth IRA’s and Roth 401k’s, is that your contributions to the traditional accounts are on a pre-tax basis. That means you get to reduce your taxable income by the amount of your contribution in the year the contribution is made. The downside is that when you take the funds out upon retiring, you’ll pay tax on the distributions. With Roth accounts, you do not get to deduct your contributions in the year they are made, so you will not see any immediate tax savings by contributing. However, the earnings made over time are tax-free, and all of your distributions upon retirement are also tax free. Of course, there are other nuances and factors to consider, but the pre-tax vs after-tax distinction is the most important difference between these accounts. Also, note that there are income limitations which may prevent a person from deducting their traditional IRA contribution, or being able to contribute at all to a Roth account (see below).
Rather than writing out all the differences between the different accounts, I’ve included the chart below which hopefully summarizes all of the key information in visual format. Note that if you’re a business owner, you have many more options for retirement contributions than if you’re an employee. However, if you own a business with multiple employees, be careful, as many retirement plans require you to match employee contributions for all employees if you do it for one (yourself).
Here are some other helpful tips that you may not have realized:
- Ordinarily one must have earned income to contribute to an IRA or Roth. However, if only one spouse is working, the working spouse can create and contribute to what’s called a Spousal IRA, on behalf of the non-working spouse.
- Roth contributions (not the earnings, but rather just your initial contributions) can be withdrawn penalty and tax free at ANY point in time. While not recommended, this can come in handy if you really get in an emergency cash crunch.
- While there has been recent debate over the following advice, historically the most common guidance regarding whether to contribute to a traditional IRA or a Roth IRA is to compare your current earnings with what you expect your income to be upon retirement. If you think your current income is higher than what it will be at retirement, then contribute to a traditional IRA to get the deduction now, while you’re in a higher tax bracket. If, on the other hand, you think you’ll be in a higher tax bracket upon retirement, then contribute to a Roth now so that you’ll get tax free distributions while in the higher bracket later in life.
- Lookout! There’s a 10% penalty, on top of being subject to tax, for any early distributions from an IRA or 401k. A Roth IRA also can have a 10% penalty for early distributions, but only on the earnings portion of the distribution, not your actual contributions.
- The IRS does allow for some early distributions from IRA’s or Roth IRA’s without being subject to the 10% penalty. Some of the most common penalty-free uses include higher education expenses, significant medical expenses, and $10,000 towards the purchase of your first home.
- Even if your income is too high to contribute directly to a Roth IRA, there is a way around this known as a ‘backdoor Roth contribution’. Ask your financial advisor about this if it applies to you.
Most importantly, this is general tax advice that may vary based on your individual circumstances. Be sure to talk to your own CPA before making any retirement contributions based on information in this article.
Want to learn more about financial security? See our post here on educating yourself when you young.