Here are a few of the main types of retirement savings accounts available to you:
401(K)
401(K)s are set up by your employer. That means you usually get a chance to sign up when you are hired or when you become eligible after working for some period of time.
Uncle Sam allows you to fund these accounts with earnings you haven’t paid income tax on. Those earnings then grow unencumbered by taxes on capital gains and dividends that usually apply to investment profits. You are required to pay up at income tax rates when you do withdraw and spend your savings in retirement. (Keep in mind, here are hefty potential penalties if you withdraw from your 401(K) early.)
Because 401(k)s are offered through employers, they have some big advantages. First is that 401(k)s are regarded as a job perk. That means you aren’t just saving on your own, there is a good chance your employer plans to kick in some money too. The amount is usually calculated as a percentage of your salary, say 3% or 5%. Some employers contribute money whether you contribute or not. But most take a slightly different approach, making at least part of their contribution in terms of a “match.” In other words, a 3% match would mean your employer matches your 401(k) contributions dollar for dollar up to 3% of your salary, which makes your effective savings rate 6%. Another big advantage of saving in your employer’s 401(k) is that, like Social Security and your health insurance premiums, 401(k) contributions are taken directly out of your paycheck each month.
Traditional IRA
We don’t all work for an employer that offers a 401(K) retirement account. The Individual Retirement Account, or IRA, which you can think of as a kind of 401(k) you set up for yourself, at a brokerage like Fidelity, Vanguard or Schwab, or even at the branch of your local bank. The tax benefits are almost identical to a 401(k). You avoid paying income tax on money you invest until you are ready to withdraw it in retirement. Since you are not contributing through your employer’s payroll department, you must typically contribute after-tax dollars, then deduct the amount of the contribution from your taxes to get the difference back from Uncle Sam.
Because 401(k)s are designed to serve as Americans’ primary retirement vehicle, there are limits on who can reap traditional IRA tax benefits. For workers who also have access to a 401(k), the traditional IRA tax deduction phases out for single savers earning $61,000 and married joint filers earning $98,000.
With a 401(k), your employer chooses the slate of investments, typically mutual funds. With an IRA you are largely on your own. You can hold mutual funds, stocks, bonds, and even exotic assets like an investment property if you really want. On the other hand, you won’t be getting an employer match, and the maximum you can contribute to an IRA is far lower than with a 401(k): $5,500 a year for those under 50, compared with $18,000 for a 401(k).
While your 401(k)’s match and convenience make it hard to beat as your primary saving vehicle at the start of your career, as you get older there’s a good chance you’ll end up with both a 401(k) and an IRA. Since your 401(K) is tied to your current employer, the system can get more clunky after you’ve switched jobs—then switched again and again. Millions of Americans who don’t contribute to an IRA directly still open one so they can “roll over” old 401(k)s into a single account rather than trying to keep track of half a dozen.
Roth IRA
The 401(k) and the traditional IRA offer the same basic tax break, allowing you to defer income tax on your savings. The Roth IRA allows you to do this backwards. You still pay taxes up front when you make a contribution. But after that, your obligations to Uncle Sam are done. You no longer have to pay income tax on the money you withdraw, and you also skip the capital gains and dividend taxes that dog investors in non-tax-advantaged brokerage accounts. (Like traditional IRAs, there are Roth limits for high earners, although the thresholds are more generous and they aren’t tied to whether or not you have a 401(k).)
Roth IRAs have one clear advantage over 401(k)s and IRAs. As with the other accounts, there is a hefty penalty for tapping your retirement savings early. But because you fund your Roth IRA with after-tax dollars, these accounts allow you to withdraw your original contributions—but not investment profits—without penalty whenever you want. That gives you an important escape hatch if you’d like to save for retirement but have competing savings goals like building an emergency fund or putting together a down payment on a starter home.
The bigger question—whether you ultimately save more in taxes by paying now or paying later—is harder to answer. The tax math hinges on whether you are paying a higher rate now than the one you will pay in retirement. Many financial planners think Roth IRAs are a particularly attractive option for young workers, who can expect to pay higher rates later in life when they are wealthier. But in the end, predicting your future earnings power, not to mention what U.S. tax brackets will be decades hence, means there is still a lot of guesswork.
Not that that should discourage you. While you’re young, the most important thing is that you start saving, helping yourself get ahead of the game. Consider the tax benefits gravy.
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