Today I wanted to discuss the two most popular retirement accounts, their advantages and disadvantages, and why you should care.
We’re going to look at the 401(k) retirement account, which is typically available to those working for bigger businesses and corporations, and the Roth IRA retirement account, which is typically used by self-employed or freelancing workers. The rules for these accounts are set by the US Government and may change after this article is published. Always check that you know the current rules before investing.
401(k)s are what we hear discussed the most. 401(k)s are typically offered by the company you work for. You can have a portion of your income contributed, before taxes, to your 401(k) retirement account. It’s important that I mention the ‘before taxes’ part, because that’s one of the biggest differences between a 401(k) and a Roth IRA. Because you contribute money to your 401(k) before it is taxed, you lower your taxable income for the year in which you contribute, which also possibly lowers your income tax bracket, saving you money at tax time.
Your employer may even match a portion or all of your contributions to your 401(k). If your employer will match your contributions, I highly advise you contribute up to the employer’s match, as this is free money every month. Your employer is not obligated to match contributions though, so not all of you will have this opportunity.
When you retire and begin taking distributions from your 401(k), those distributions are taxed at your future income tax bracket because you contributed the money pre-tax while you were working. So all of the wealth you’ve accumulated in your 401(k) will be taxed as you withdraw it after retirement. As you will soon see, this is another big difference between 401(k)s and Roth IRAs.
So what’s a Roth IRA?
Roth IRAs are retirement accounts you set up individually, outside of your employer. Roth IRAs are one of the few (but not only) retirement account options for self-employed workers. The money you contribute to a Roth IRA is after tax money. You’ve already paid income tax on this money. Because of this, when you begin taking distributions from your Roth IRA upon retirement, your distributions are tax free. You won’t pay a penny of tax on distributions of your original contributions nor the decades of growth and interest and dividends within your Roth IRA account. This is what makes Roth IRAs so attractive.
One drawback to the Roth IRA is the low annual contribution limit. You are only allowed to currently contribute $5,000 per year to your Roth IRA. And if you miss a year, or don’t contribute the full $5,000, you’re out of luck – you can’t make that time up. This is why it is so important to open and start contributing to a Roth IRA when you’re as young as possible. Even if you only put in $20/month, it’s better than nothing, and it’s time that you won’t be able to get back.
The later you start, the harder you have to work and the more you’ll have to save. By starting early, even with smaller amounts, your money will have more time to grow, compound interest will display its positive effect on your cash, and your nest egg will grow beyond belief. If you wait until you’re 40 to start, you’ll have to work five times as hard, for half the reward.
No one has retirement on the brain at 18 or 19 years old, but if I could change just one thing about my financial past, it would be starting a Roth IRA right out of high school instead of waiting until I was 25. I cannot stress this enough, knowing that 41% of my readers are under 18, and another 17% are under 24.
If you’re currently working for a company that offers a 401(k) plan, ask them about employer matches and start contributing. Then, whether your employer offers a 401(k) or you work for yourself, everyone is able to open a Roth IRA account. So do that. It doesn’t cost anything to get started, and you can contribute as much or as little as you can afford each month (up to the $5,000 annual limit).
Roth IRAs can be set up online at E*Trade (which is where mine is), T. Rowe Price and many other online brokerages. Don’t worry about what to invest in within your Roth IRA yet, just get it started, and start contributing. We’ll have plenty of time to talk about investment options later, or you can reread yesterday’s article for some brief overviews of the investment options available to you.
No one wants to retire to a restrictive budget and a menu of cat food. And you won’t have to, if you just start early, and contribute often.
{ 9 comments… read them below or add one }
Am I the only person who uses not a Roth IRA but a SEP-IRA?
(And are they the same thing?)
@John They are not the same. SEP-IRA is before tax contributions, which means you’re lowering your tax liability now, but you WILL be taxed on any distributions you take when you retire.
The Roth IRA, on the other hand, is after tax money and your contribution grow TAX FREE. When I begin taking distributions from my Roth IRA, that money will be 100% tax free… but when you begin taking distributions from your SEP-IRA, you will be taxed, just as you are now, on that income.
Also, it looks like you can contribute a higher dollar amount annually to a SEP-IRA than compared to a Roth IRA, based on your income.
There also exists a little-known Roth 401k. My employer’s 401k plan offers me both Traditional and Roth options, and I can choose to direct a percentage of my pay to either or both of them. This allows me to use the Roth option and still take advantage of the employer match. (Or rather, I did until they eliminated matching last year in the economic downturn, but maybe your employer still offers it.). In addition, self employed people can choose to open a Traditional IRA or a Roth IRA, giving them some choice in how they want to handle the tax situation. In both 401k and IRA accounts, “Traditional” means you get a tax break now, pay taxes on that $ when you retire. “Roth” does not reduce your taxes now, but you get to take it out tax-free when you retire, as Alan explained.
There’s lots written elsewhere on why an individual would choose Traditional vs Roth, and it has to do with your years to retirement, current tax bracket, expected tax bracket during retirement, and other factors, but as a young person with lots of years to retirement, I go all Roth.
Does age play a part in whether you can open a Roth IRA or 401K?
@Nathan, I believe you must be 18 years old to open either type of account.
etrade offers an IRA for minors. Would it be worth me starting now to build that, and if i did, would that roll over into a Roth IRA when i turned 18(Currently 16)?
Too bad you didn’t start your IRA until you were 25. I’m 33 and I don’t have one! Though, I’m gonna look into it now that I know what it is.
And just curious – how do you know the demographics of your readers?
@Nathan, I’m not sure, give E*Trade a call, their number is 1-800-ETRADE1.
@Shawn, my readers come from my YouTube and Twitter audience. I have analytics available to me from YouTube that break down the demographics.
Great Info. Alan. Buck sent me, & now I have you on my Reader.