Now that we have a basic understanding of how income tax works, we’re ready to discuss a set of very powerful tools to help you along the road to financial independence: retirement accounts. Think of retirement accounts as special baskets that provide certain tax benefits in which you can place your money. This is the government’s way of incentivizing saving for retirement, and you should take full advantage of it as soon as possible. Unfortunately, most people don’t. According to this article in The Atlantic, TWO THIRDS of Americans don’t use retirement accounts at all. In one of the most popular types of retirement accounts, the 401k, the median savings of an American between 55 and 64 years of age is a mere $15,000–that is scary! Lucky for all you M+M readers, this will not be you! Or if it is you, it won’t be for long.
There are several types of tax-advantaged accounts, each with their own set of rules and criteria for eligibility. Here I will discuss the most common types, which also provide a framework for understanding other types of retirement accounts that you may have access to. Also, while it’s possible (and highly recommended) to invest the money within a retirement account, the account itself is not an investment. For example, if I contribute $1,000 to my IRA and just let it sit there, nothing will happen. I have to actually log in to the account, choose an investment (like VTI, for example), and buy that with my $1,000. Confusing contributing to the account with actually investing the money is a common and very costly mistake.
The Traditional 401k
This type of retirement account is typically provided by your employer. The employee can elect to have a portion of their pay be placed into the 401k, up to $18,500 per year1in 2018. These numbers can change slightly from year to year. Since the employee does not actually get paid this money, it does not get taxed. The money in the 401k can then be invested, where it will continue to grow tax-free. After age 59.5, money can be taken out of the 401k, at which point it will be taxed as ordinary income. After age 70.5, you’re required to make minimum withdrawals each year. The advantage of the 401k is that it reduces your tax rate during your working years, when it is high, and you can instead pay taxes on that money in retirement, when your taxes are probably lower.
Sometimes, an employer will match a portion of contributions to a 401k. If your employer does this, you should ALWAYS take advantage, as this is literally free money. Because the 401k itself is provided through your employer, you don’t get to choose which company it’s through, so you may not have access to Vanguard index funds. If you don’t, that’s ok, just choose another index fund that covers as much of the US market as possible. The S&P500 is a close enough approximation if that’s available. Lastly, there are a couple other accounts that work similar to a 401k (like a 403b, for example) which might be available to you instead of a 401k depending on where you work. 401k’s (as well as Traditional IRAs) are known as tax-deferred or pre-tax accounts since the money you put in is “pre-tax”, or before you pay taxes on it.
The Traditional IRA
Individual Retirement Arrangements, or IRAs, are accounts that you open as an individual, i.e. not through your employer. Thus, you are free to open an IRA with Vanguard, where you can access their funds. The Traditional IRA is similar to the 401k in that it is pre-tax money that you contribute and you pay income tax on withdrawals, which you can make after age 59.5 (with some exceptions). However, there are income limits above which contributions to a traditional IRA will not be tax deductible2The ability to deduct contributions actually depends on your income AND whether or not you have access to a retirement plan at work, as described here: https://www.irs.gov/retirement-plans/ira-deduction-limits. The maximum contribution is $5,500 per year (2018 numbers).
Note that you can max out BOTH your 401k and Traditional IRA contributions for $24,000 of tax free contributions per year. Also note that contributions to a 401k and/or Traditional IRA are deducted FOR rather than FROM adjusted gross income3Translation: take your income, subtract deductions FOR adjusted gross income (like Trad IRA contributions) to get adjusted gross income. Next, take adjusted gross income and subtract deductions FROM adjusted gross income like the standard deduction or itemized deductions, whichever is larger, to get taxable income. Still confused? Go back and read my last post!, which basically means that they don’t interfere with your ability to take the standard deduction. Thus, assuming you max out your 401k, are eligible to make tax deductible contributions to a Traditional IRA and max that out, and take the standard deduction ($12,000 for single filers), you will not owe federal income tax on a whopping $36,000 of your income! Sweet deal!!!
The Roth IRA
The other flavor of IRA is the Roth IRA. This is basically the reverse of the Traditional IRA: money you contribute is post-tax, but withdrawals (which can begin at age 59.5) are completely tax free. The maximum yearly contribution limit is the same: $5,5004This limit is a total for IRAs, i.e. if you contribute $2k to a Trad IRA, you can only contribute $3.5k to a Roth. Additionally, you are only eligible to contribute below certain income limits. Roth IRAs also have several unique advantages. First, you can take out principal (the amount you put in, but not any money your investments made) at any time without penalty. Once you’ve had the account for 5 years, you can also take out $10,000 without penalty to go toward a first time home purchase.
The conventional wisdom in personal finance tells us that Roth IRAs are a good option if your income is not high, whereas traditional is a better option if your income is a bit higher. But if we all follow the conventional wisdom we’ll probably end up being as bad at money as the average American. As it turns out, the Roth vs Traditional decision has a pretty clear choice in almost all cases, and if you’d like to find out what/why that is, come back to read my next post!
Summary (aka the entire post in a small table)
|Account||Provided Through Employer?||Tax deductible (pre-tax) contributions?||Tax on withdrawals?||Maximum yearly contribution||Income limits for contribution?|
|Traditional 401k||Yes||Yes||Yes, income tax||$18,500||No|
|Traditional IRA||No||Yes||Yes, income tax||$5,500 total for all IRAs||Yes, for tax deductibility|
|Roth IRA||No||No||No||See above||Yes|
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PSS A note for graduate students: If you’re a grad student getting paid a stipend, you may or may not be eligible to contribute to an IRA (and God knows they definitely don’t give you a 401k!). To be eligible, you need to have earned income. If you receive a W2 at the end of the year, you should be able to contribute to an IRA. If you don’t, or if the words Service Free Stipend sound familiar to you, then you probably can’t. But fear not, we’ll learn in a later post that you won’t really have to pay taxes in retirement anyway!