If you are reading this post, please stick around especially if you are young. The further away you are from retirement, the more opportunity you have to secure yours.
Too many people make the mistake of waiting until its too late. It is also important to understand that even though you are putting your money in these accounts when you are young, the money isn’t gone and you can still benefit from it before you retire.
Retirement Accounts are special investing accounts that allow you to legally avoid paying taxes on your money now or later. With a typical investing account, you will contribute money to it that you make at your job. This money is taxed by the IRS in the United States through income tax (State and Federal). After you pay taxes on the money, you can then invest it into whatever funds or securities you want to. Later down the line when you sell those securities for a profit, you will again have to pay taxes on the increase of value. Retirement Accounts provide an avenue to avoid one of these two taxable events.
Roth vs Traditional Accounts
The names “Traditional” and “Roth” simply refer to whether they eliminate tax now, or tax later. If you have a Traditional retirement account you can save money on taxes now. For example, say you are working your first job and decide to take $2,000 of your wages and invest them into your Traditional retirement account. Since this is a government sponsored plan, that $2,000 will effectively reduce your taxable income by $2,000. This means that if you are a single person making $60,000, that your tax rate for that income is 22% (according to the table below). In other words, you will save $440 on taxes this year just from setting aside some of your money for retirement.
| Tax Rate | Income Range (Single) | Income Range (Married) |
|---|---|---|
| 10% | From $0 to $11,000 | From $0 to $22,000 |
| 12% | From $11,001 to $44,725 | From $22,001 to $89,450 |
| 22% | From $44,726 to $95,375 | From $89,451 to $190,750 |
| 24% | From $95,376 to $182,100 | From $190,751 to $364,200 |
| 32% | From $182,101 to $231,250 | From $364,201 to $462,500 |
| 35% | From $231,251 to $578,125 | From $462,501 to $693,750 |
| 37% | From $578,126 and up | From $693,751 and up |
As for Roth accounts, you will not experience any tax savings when you contribute money. This is because Roth accounts offer tax free deductions later on down the line. If you are at least 59 1⁄2 years old and have had your account for at least 5 years, all money you withdraw will be tax free. This will not affect your tax return this year, but you will be giving your future self some relief.
To decide whether Roth or Traditional is right for you, you should ask yourself several questions:
1. When you retire, will you be in a higher tax bracket?
If you think that you will be wealthy when you retire, then a Roth is probably better since you would avoid paying taxes at a high tax bracket. If instead you think you will be making less money than you are now, you may be in a lower tax bracket so a Traditional account may make more sense; avoid the high taxes while you are working and pay the low taxes later.
2. Do you think taxes will go up over time?
If you think tax rates will go up as time passes, then you may be better of going the Roth route. Since you would be paying taxes now, you would avoid high taxes in the future. (Most people tend to think that taxes will go up).
3. How will you most benefit from stress?
Some of this is also just how you feel about the situation. Are you happy knowing that you saved money this year and putting off the problem until later, or do you prefer paying now and not having to worry about it later?
401K vs IRA Accounts
A 401K account is an employer sponsored retirement plan. Employer sponsored means there are typically a limited number of things you can invest in. The main number to keep in mind about this account is the annual contribution limit. For 2023, the individual contribution limit is $22,500 (there is also a limit for employer contributions but this is typically large enough to not have to worry about). These limits will typically increase over time and can change year on year.
Many employers actually offer matching contributions to this account. For example, say you work for a company making $60,000 a year and they offer a 5% matching program. If you contribute $5,000 to your 401K, your company will also match up to 5% of your salary, so in this case they will contribute $3,000. That is a free $3,000 that I definitely recommend taking advantage of, it is free money.
An Individual Retirement Account (IRA) is an individually controlled retirement plan. This means that you are able to pick what to invest in with all the options of a normal brokerage account. This is nice as well because if you change jobs, it is still just one account you control. In the case of a 401K, you would get a new employer account and have to worry about transferring funds or keeping track of multiple accounts.
With these two types of accounts, this means there’s a whole another dimension to picking retirement accounts. Not only do you have to pick Traditional vs Roth, but you also need to pick between a 401K and an IRA. Those of you who are good at math may already realize this results in 4 different possibilities for accounts. All of the information is summarized in the table below (limits for 2023).
| Traditional | Roth | |
| 401K | $22,500 contribution limit Tax deferred until retirement Account attached to employer | $22,500 contribution limit No tax break now, no taxes later Account attached to employer |
| IRA | $6,500 contribution limit Tax deferred until retirement Account managed by you | $6,500 contribution limit No tax break now, no taxes later Account managed by you |
Make sure that whatever combination of accounts you choose, your total 401K contributions (Roth and/or Traditional) cannot exceed the $22,500 contribution limit, and your total IRA contributions cannot exceed $6,500. There is also an income limit for the Roth IRA, you must have an income of less than $153,000 (or less than $228,000 if married).
Withdrawals
Like mentioned above, you can withdraw money from these accounts without penalty after having the accounts for 5 years and being older than 59 1⁄2 years old. There are many different exceptions to this rule that you as an account holder can take advantage of. As an example unique to the Roth IRA, you are able to withdraw your contributions tax free and penalty free whenever. This is one of the simpler exceptions and they can get more complicated. Other exceptions allow you to withdraw some money if you are a first time home buyer, taking out loans from yourself, for medical reasons, etc. In general, it is typically preferred to keep the funds in the accounts for as long as you can so they can grow by compound interest. If you can avoid taking out money before you are able to retire, that’s usually your best bet.
Deciding What to Do
This financial year, the maximum amount of money you can contribute in total to retirement accounts is $22,500 + $6,500 = $29,000. This is a large amount of money, but you can still take advantage of the benefits of retirement accounts even if you just set aside a fraction of this amount. The most important retirement account to contribute to is the one that will get the max matching from your company. If your company offers 4% matching of your salary, then contribute 4% of your salary (unless you have high interest debt to pay off). After committing this amount, the rest is going to depend on your financial goals and how much you can afford to put away. The further you are from retirement, you can get away with contributing less since your money has time to grow. General estimates of what you can save recommending trying to put at least 10% of your money away from retirement.
Most of the people I talk to are younger folk, and I typically recommend that they put more of their money into Roth accounts, whether it be a Roth 401K or a Roth IRA. This is because they expect taxes to go up, and they like the idea of paying tax now to not have to worry about it later. Be careful though, some companies will only match contributions into a Traditional 401K. You can always split it though, just contribute enough to the Traditional 401K to get the matching, and the contribute the rest to the Roth 401K.
Before making financial decisions like deciding what type of retirement account you want to contribute to, or how much to contribute to it, make sure to do your own research and/or consult a financial expert.
Check out this post about what assets to pick for your retirement accounts.