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Retirement Accounts – What Is A 401k Anyway?

Retirement isn’t on the radar for most college graduates dealing with student loan debt, but it’s never too early to plan for the future. And like student loans, there’s a lot of unfamiliar and confusing terminology. Learning about financial assets like stocks and bonds can be bewildering, especially when taxes come into play. Financial products are often less complex than they’re made to seem though. For many in the finance industry, making things seem overly complex is the meal ticket. Because the more confusing it is to you, the more you’re going to need their “expertise”.

Except this financial promotion machine ignores a core truth – keeping it simple is usually the best strategy. For the overwhelming majority of Americans, there are two retirement savings vehicles to consider: the 401k and the Roth Individual Retirement Account (IRA). Yes, there’s plenty of other options like annuities, pensions, and self-employed IRAs, but these are the two you’ll be dealing with. So what’s the difference? You can buy the same financial products and will face the same age restrictions on withdrawals, but up for consideration is how much you want to contribute and when you want to pay your taxes (and I do mean WHEN).

Pensions Are A Thing Of The Past

 

The 401k is named after it’s section in the tax code and became popular during the 1980s, when corporate pensions started disappearing. With pensions, the employer buys financial assets and funds the retirement of their workers. The company makes contributions and investment decisions, but also bears all the risk. If the stock market drops 10%, the employer has to eat the loss. But since legislature passed in 1978, pensions have been phased out by firms in the United States.

The 401k plan was designed to shift the burden of risk (and funding) from the employer to the employee. With large companies struggling to pick up the bill for all their retired works, the defined contribution plan was born. Plans like the 401k allow employers to fund a portion of an employee’s retirement while surrendering control of investment decisions. By 2013, only 24% of S&P 500 companies remained on the pension plan system.

The Federal Government Picks Up Some Slack

 

The 1978 tax law didn’t fully shift the burden of retirement saving onto employees. One of the provisions in Section 401k gives tax breaks to people who fund their defined-contribution retirement plans. Using a 401k, workers put part of their own income into the plan with the company matching up to a certain percentage. The workers buy their own financial products and make their own investment decisions. It’s the same mechanics as a pension plan, but the government is willing to chip in with a deep discount.

When you contribute funds to a 401k, they are NOT taxed. Your contribution is automatically taken out of each paycheck and deposited into an account with being subject to any taxes. By keeping more of your paycheck, you’ll be able to invest larger amounts and build up a nest egg faster. The taxes will be due when you take money out of the account, usually when retirees are in a (much) lower tax bracket.

A certain percentage of your contribution might be matched by your employer, say 5%. This is FREE money. I repeat, FREE money. You won’t find this kind of free cash with loan refinancing, credit card rewards, or bank account signup bonuses. If you make $30,000 annually and save 7% of that with a company match in your 401k, your employer will give you an extra $2100 per year. Again, this is FREE money and so find a way to fit retirement saving into your budget.

Roth IRAs vs 401ks

 

The Roth IRA was the brainchild of William Roth, a senator from Delaware. Roth wanted a retirement account where contributions were taxed on deposit, instead of in the future at withdrawal. Thus the Roth IRA was launched, where workers can pay taxes up front on their deposits and take the money out tax free at age 59½. Yes, the honest-to-God age you can withdraw funds from both Roth IRA and is 59½ .

The 401k and Roth IRA both have limits on the amount of money you can put in annually. A Roth IRA allows up to $5,500 in contributions per year, while the 401k lets you put in a much more generous $18,500. With a Roth IRA, taxes are paid up front when the funds are pulled from your paycheck. Using a 401k means your taxes will be paid when you withdraw your money at retirement and not when you deposit it.

While not as charitable as pensions, both 401ks and Roth IRAs give workers a way to build up retirement funds. Which you choose depends on your situation, but you can fund BOTH accounts simultaneously. If you’re just starting your career and reside in a lower tax bracket, it might make senses to start a 401k and pay your taxes now. But if you’re established in your job and making good money, fund the Roth IRA first before moving on to the 401k. Your retirement decisions are in your hands now and mistakes can be costly. Do your research on your company’s offerings before making a choice.

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