It feels like one of the unfair expectations we set for ourselves as adults, is that we automatically understand all the confusing financial terms out there.
At our first job, we sit down with the HR Manager and as he or she goes over all the 401(k) options, we try to look like we know what they are talking about.
You start talking to another dad at your kids soccer game and as he talks about how he is planning to start funding his Roth IRA, you nod your head along trying to show that you understand what he’s talking about.
And we kick ourselves for not knowing.
Well I’m here to tell you not to be so hard on yourself.
401(k)s, IRAs, Roth – these are terms that are thrown around in the personal finance space. And people have an expectation that you know what they are.
But how can you when you’ve never formally learned them?
This has nothing to do with your intelligence. You’ve just never been taught. I don’t know about now, but when I was in school I don’t remember ever being taught how to navigate my company’s HR packet.
I’ve been working professionally for almost 20 years and it wasn’t until just a few years ago that I felt I had a decent grasp of these concepts. And most of this I had to learn on my own just like you.
So, today. I want to go over the basics of what these retirement savings plans are so that next time you are at your daughter’s ballet recital – you could be the one jabbering about how you are thinking about rolling over your 401(k) to an IRA.
Trust me, your fellow parents won’t be annoyed at all. They’ll actually be impressed.
Retirement Savings Plan Fundamentals
Alright. First, let’s start out with some fundamentals.
When I talk to people about 401(k)s or IRAs, people often confuse them as investments themselves.
And don’t feel bad if you’ve done it as well. I’ve been confused as well and we all start from somewhere.
Rather, we should think of 401(k) or IRAs as buckets that hold the investment that we choose. And these investments could be single stocks, actively managed mutual funds, or my favorite low cost index funds.
And these “buckets” are quite important because by putting our investments into these designated retirement savings plans, we are able to take advantage of tax benefits provided by Uncle Sam. And Uncle Sam wants you to invest money into these buckets so you can be financially ready for retirement – thus all the tax benefits.
You can still have investments outside of these buckets, but they won’t be able to take advantage of the tax benefits provided by the retirement savings plans. They can be broadly categorized as “ordinary buckets” vs. “tax-advantaged buckets.”
For the purpose of this article, I won’t be talking about ordinary buckets, but we’ll focus specifically on “Tax-Advantaged Buckets.”
One thing to note is that “tax-advantaged buckets” doesn’t mean that you avoid paying taxes. They don’t eliminate your tax obligations. I’ll explain more in detail later in the post, but just know that you will definitely pay less, but still pay some taxes when you are using these buckets. The timing will differ based on the type of account.
Also, there are penalties for trying to access this money early. Currently as it stands you will pay a penalty if you withdraw before the age of 59.5.
Employer-Based Tax-Advantaged Buckets
Alright, now that we’ve covered some fundamentals, let’s dive into specific buckets.
I’ll cover the most common Employer-Based retirement savings plan.
If you have a traditional job, most often they will have a 401(k) as part of their benefits package with loads of other benefits like healthcare, disability insurance and/or wellness support.
There is also the 403(b). These are offered to employees of public schools and certain religious or charitable organizations. For simplicity’s sake, since 403(b)s are similar to 401(k)s, I’ll refer only to 401(k)s throughout the rest of this post.
Tax Advantage – For me, the most obvious reason to contribute money to a 401(k) is the tax advantage. For a 401(k), when you make a contribution, you can deduct that amount from your income for tax purposes. For 2022, the contribution cap is $20,500 per person per year. Add another $6,500 to that if you are 50 and older.
If you are fortunate enough to be in a higher tax bracket, this benefit is huge.
Let me show you an example. Let’s say that for 2022, you are fortunate to be making more than $83,550 combined as a family. The marginal federal tax rate for a family making more than $83,550 and under $178,150 is 22%.
If you contribute the max amount and your contribution can lower your taxable income level to below this bracket, then you are saving $4,510 in taxes. 22% of $20,500.
Essentially, instead of paying $4,510 in taxes, you are putting that money into the market to work to grow your net worth.
Ofcourse, you need to pay taxes when you withdraw, but the initial contribution is tax deductible and the growth is all tax deferred until your withdrawal .
And as I stated earlier, any money withdrawn before 59.5 is subject to penalty, so make sure you do your best not to touch it before then.
Another thing to note is that, after 70.5, your money is subject to RMDs, Required Minimum Distributions. I won’t go into too much detail here, but just know that you will eventually need to withdraw your money from this account because Uncle Sam will eventually want your taxes.
Investment Options – The investment options will depend on the investment company that your employer is working with. And the investment company will narrow down the investment options for you. Most plans that I’ve seen have a range of actively managed funds, target date funds and some index funds.
If your investment company happens to be Vanguard, then you are in luck. You can choose from its selection of low cost index funds. My favorite is VTSAX if your company offers it. But you can’t go wrong with most of its low cost well diversified index funds. However, even if Vanguard isn’t your investment company your employer has chosen, that is ok. Most 401(k) plans should have at least one index fund option. Make sure to check the expense ratios though.
This was the case for me. My company was partnered with Fidelity, but thankfully there was a S&P 500 Index Fund with a pretty low expense ratio that I was able to go with.
For some reason, you don’t see a low cost index fund as an option, it may be time to talk to your HR Office.
Match – If your employer is nice, they will also offer a match to your contribution. This can range from 3% – 6%. What this means is that, if you make $100,000 annually and your employer matches up to 5%, then when you contribute your 5%, $5,000, your employer will also contribute their 5%, another $5,000. This is free money. If your company matches, make sure to invest at least up to the match.
Rollover – In today’s economy, it’s rare for someone to stay with one company throughout their career. So, when you leave your current employer, know that you can roll your 401(k) into an IRA, preserving its tax advantage. Some employers will allow you to continue holding your 401(k) in their plan, but if you want more control, know that you don’t need to keep your money there.
Some of you guys might have heard something called a Roth 401(k). It wasn’t available at a lot of places before, but I’ve seen it being made more widely available the last few years. This will make more sense when I review Roth IRA in the next section, but the main thing to note here is that, everything else being similar (investment option, withdrawal penalty, etc.) contributions you make are NOT deductible from your income for tax purposes. My recommendation is that if you are in a higher income bracket where you are paying a pretty sizable amount in taxes, you should opt for a traditional 401(k) so you can save money in taxes and be able to invest more in your accumulation phase of life.
Individual-Based Tax-Advantaged Buckets
Let’s move onto individual-based tax advantaged buckets. IRAs – Individual Retirement Accounts.
Unlike an employer-based tax advantaged bucket like a 401(k), these are not tied to your employer.
You have complete control over them. This could be good for some. Maybe bad for others? I hope not.
I’m a control freak, so I personally love these IRAs. I can select the investment company and the investments I want for my IRA.
There are many types of IRAs, but for simplicity sake, in this post I’ll cover the 2 most common ones. The traditional IRA and the Roth IRA.
Let’s start out with Traditional IRA. Or also known as the Deductible IRA.
Contribution Limit – For 2022, the contribution limit is $6,000 per year. Add another $1,000 if you are 50 and older.
And this is separate from your employer based plan cap. So, if you are hardcore, in 2022 you can essentially max out your 401(k) with $20,500 and another $6,000 with your IRA. You could be putting $26,500 into the market annually and double that if you are married.
Tax Deductible – Like a traditional 401(k), contributions you make are deductible from your income for tax purposes. So again, if you max out your $6,000 and you are in a 22% tax bracket, you can be saving $1,320 from going to Uncle Sam and rather be going into your investment, growing your net worth.
But the deductibility is phased out over certain income levels so make sure to check the IRS website for the latest updates.
And similar to a traditional 401(k), while all your investment growth is tax deferred, you will need to pay taxes when you withdraw your money.
Money drawn before 59.5 is subject to penalty, so practice caution and after 70.5, your money is subject to RMDs as well.
The second type of IRA I want to discuss is the Roth IRA.
The key difference between the Roth IRA and the traditional IRA is the timing of their tax advantages.
With the traditional IRA, you deduct contributions now and pay taxes on withdrawals later.
IRA works the opposite. You pay taxes up front. But you don’t have to pay taxes on your withdrawals.
However, note that eligibility to contribute is phased out over certain income levels.
So if you feel like you will be hitting this ceiling eventually, consider investing in a Roth IRA as soon as possible so you can take advantage of the tax free withdrawals eventually.
The great thing I like about the Roth IRA is that, not only are all earnings on your investment grow tax-free, all your withdrawals after 59.5 are tax free.
Unlike a Traditional 401(k) or IRA where you know you’ll need to pay Uncle Sam his taxes down the line, you are free and clear with a Roth.
Another thing to note is that you can withdraw your original contribution anytime, tax and penalty free since you’ve already paid your taxes on them.
But I’d recommend refraining yourself from doing this because you want that contribution to compound.
Summary Of Retirement Savings Plans
Alright. If you’ve stayed with me so far. Congratulations!
I know I may not be the most pleasant person to watch for this long, so I appreciate you bearing with me.
Before I go over my recommendations on how to approach these plans, let me quickly summarize what we just went over.
- 401(k) = Immediate tax benefits and tax-free growth. But taxes are due when the money is withdrawn.
- Roth 401(k) = No immediate tax benefit, tax-free growth and no taxes due on withdrawal.
- Traditional IRA = Immediate tax benefits and tax-free growth. But taxes are due when the money is withdrawn. Deductibility is phased out over certain income levels. Check the IRS website for latest updates.
- Roth IRA = No immediate tax benefit, tax-free growth and no taxes due on withdrawal. Eligibility to contribute phases out over certain income limits.
My Recommendation For Order Of Filling These Buckets
To simplify your takeaways, my 4 step recommendation for filling these buckets would be in the following order.
- 1 – If your company has a Traditional 401(k) match, fund it until you get the match. This could be 3% to 6% based on your company’s offering. Fund it up to the match percentage.
- 2 – Fully fund the Roth IRA, this is $6,000 per individual for 2022. If you don’t have one yet, you can easily open up with any brokerage company of your choice. Of Course my favorite is Vanguard.
- 3 – After maxing out your Roth IRA, go back to your 401(k) and fully fund it to the max. This is $20,500 for 2022.
- 4 – And if you still have money available to invest, this is when I’d recommend you open up a taxable brokerage account to invest your money in. But do this only after you’ve maxed out all your retirement savings plans.