By this point, you’ve heard me rave about the benefits of investing in retirement. Perhaps you’ve been won over and are excited about the idea of getting started, but you feel like you don’t know where to begin. You’re not alone. Let’s look first at the basics of how a 401k and a Roth IRA work in order to lay the groundwork for beginning your journey to investing. In a future post, we’ll go step-by-step through how to actually start a retirement account, but it’s important to have this understanding first.
There are two main types of retirement accounts that we’ll focus on: a 401k and an IRA (Individual Retirement Arrangement).
Before we look at why these are valuable, consider why you wouldn’t want to just open up a regular account and start investing money for retirement on your own without them. You can absolutely do this, but the problem is that you will pay loads of taxes on the money you put in. You’ll be paying income tax on the money when you earn it from your job via Income Tax. On top of that you’ll be taxed on all of the great earnings that your investments made when you withdraw money, which is known as Capital Gains tax. This is a huge amount of taxes and money down the drain for you.
You can think of a 401k or a Roth IRA like a bucket that you can put your investments in to shield them against taxes. The main difference between them is the point in life at which you choose to pay the taxes.
With a 401k, all of the contributions you make are tax-free, meaning that if you contribute $10,000 to your 401k in a year, you don’t have to give Uncle Sam any of that money like you normally would when you get money in a paycheck. Essentially, the money gets filtered into your 401k before the government has a chance to grab any of it from you. If you were in the 25% tax bracket, this would save you $2,500 in taxes right off the bat. Also, you won’t have to pay taxes on any of the growth of that money (capital gains). The downside with the 401k, however, is that you will have to pay your taxes in retirement when you take the money out. If you’re rich in retirement and are “earning” more income by withdrawing from your investments than you were when you put the money into your account, you’ll be paying a higher percentage in taxes at that point.
With a Roth IRA, you pay your taxes up front and never have to worry about paying any taxes on your investments in the future. So, if you had that same $10,000 to invest in a Roth IRA and were in the 25% tax bracket now, you would pay the $2,500 in taxes up front and the other $7,500 would go into your Roth IRA. These taxes just get taken out of your paycheck like they normally do with any paycheck. Then, you invest that money in your Roth IRA. This may seem like a worse option than the 401k at first glance, but when you look at the long-term effect of not having to pay taxes in retirement, it’s pretty awesome. The Roth IRA is generally best if you expect to be making more in retirement than you’re earning now from your career. The reason is that you can pay the lighter tax load now and your money can grow to enormous numbers without you having to worry about paying steep taxes later.
The general rule of thumb is that if you’re fairly young (under, say, 35) and early in your career, you probably want to put your money in a Roth IRA. This is because your income tax bracket is significantly lower than it likely will be after you’re retired.
For both the 401k and the Roth IRA, there are limits to how much you can put in each year. For a 401k, the limit is currently $17,500, while you can only put $5,500 into a Roth IRA each year. A good strategy that I personally use is to start out putting whatever percentage your company will match, if any, into a 401k. Then, put the rest into a Roth IRA to get yourself up to 15% altogether. If you hit the maximum on your Roth IRA in a year, then go ahead and start maxing out your 401k.
To put this into a practical example, assume you make $50,000 per year. 15% of your salary would be $7500. If your company matched 2%, you would put 2% of your salary each month into your 401k and 13% into your Roth IRA. After about 10 months, you would reach the $5,500 maximum in your Roth IRA and would then contribute the full 15% to your 401k until the end of the year.
If you’re married, the contribution limits are on a per-individual basis. This means you and your spouse can each have your own accounts with $17,500 for your 401k and $5,500 for your Roth IRA. As a result, if you’re married, your limits are really $35,000 and $11,000. Not too shabby!
Hope this was helpful to you. These tax concepts can be pretty confusing at first, so as always, feel free to leave any questions you have in the comments and I’ll do my best to answer them.