Adulting 101 Part 2: Tax-Advantaged Retirement Accounts

So, long story short for our previous post about taxes: the government wants to take your money. Sounds about right. The nature of the government however, is that they want its citizens to have certain behaviors. One of those behaviors is saving for retirement, because a bunch of poor, old, sick people is a huge problem for the nation. That’s why the government is willing to give tax breaks if you’re saving for retirement.

 

The short spiel of retirement accounts is that if you put money into these accounts, you can save money on taxes. The draw-back is that if you take out the money before a certain age (usually 59.5 years old), you will get penalized for taking out that money. Ok, let’s begin with the three major ones.

 

401(k)

 

The 401(k), named so because the bill section that created this particular account, is the retirement account you think of when you think of employer pensions. If you work for a company, chances are that they offer a 401k. 

 

When you contribute to a 401k plan, a portion of your paycheck goes to the 401(k). The amount you decide to contribute is up to you, and your employer may match a portion of your contribution. This is essentially free money, as long as you wait down the road.

 

Oftentimes, this money gets routed into a “target date fund” by your employer. Target date funds attempt to reach a certain amount of money by the time you retire (the target date). These funds funds are usually a balance between the amount of time to reach a target number, the amount needed to reach a target number, and the risk taken by the individual investments made by the fund. If you want to decide where to invest your 401k money yourself, you’ll have to work that out with your employer.

 

The 401k is a tax-deferred plan, which means that you don’t pay taxes upfront. When you contribute a portion of your paycheck to a 401k, that money doesn’t get taxed. Instead, it goes straight into a fund that grows money. When you reach retirement age and start withdrawing money, then your money gets taxed. 

 

When you reach 70, you have to have a required minimum distribution. This means that you are required to withdraw a minimum amount of money out of the 401k every year after 70. This can be bad for people who want to keep their non-taxed money in their 401k to keep growing.

 

Typically, people make less income when they retire. This usually makes the 401k a good deal, since the money you withdraw from your 401k is taxed much less. Between compounding interest of a contribution that’s not taxed, employer matching, and a deferred tax rate that’s usually lower, the 401k is a good deal for a lot of people.

 

Traditional Individual Retirement Account (IRA)

 

The traditional IRA is essentially an individual version of the 401k. This is also a tax-deferred plan. When you contribute to a traditional IRA, this contribution does not get put directly taken out of your paycheck. Instead, you claim an above-the-line deduction during tax season, meaning that the portion you contributed doesn’t get taxed, and is a deduction added upon the standard deduction.

 

Otherwise, the mechanics of the traditional IRA are essentially the same as the 401(k), but you also get more control of your investments right off the bat. 

 

Roth Individual Retirement Account (IRA)

 

The Roth IRA is an interesting retirement account that was created by Senator William Roth. The uniqueness of the Roth IRA mainly involves the different tax structure compared to the Individual Roth Account.

 

When you contribute to a Roth IRA, you can’t claim a deduction. In other words, the money you contribute to a Roth IRA gets taxed. This doesn’t sound great, but the trade-off is that when you withdraw from the Roth IRA after retirement, nothing gets taxed. Moreover, there is no required minimum distribution.

 

The Roth IRA is also unique in its special form of withdrawal penalties. If you withdraw purely the principal (the amount of money you contributed into the fund, and not the amount of money that was grown), you don’t get penalized or taxed on that. You will get penalized and taxed on earnings if you withdraw before retirement age, though.

 

Roth IRAs are also strange in their income limits. If you make more than $135,000 in modified adjusted gross income (income after certain deductions), then you can no longer contribute to a Roth IRA.

 

Capital Gains Tax

 

Another advantage of all these retirement accounts is the lack of a capital gains tax. In non-tax-advantaged accounts, selling an investment will result in realized income, meaning this counts as income that needs to be taxed. As long as the money is kept in the account itself, and switched to a different investment instead of ending up as cash in your checking account, nothing gets taxed.

 

Contribution Limits

 

As of 2019, employees can contribute a max of $19,000 to a 401k themselves. This does not include employee matching. (Under 50) Individuals can contribute a max $6,000 total between the traditional IRA and the Roth IRA.

 

Flashy flashy

 

So I kind of lied about the Roth IRA income limit. For high-income individuals, there exists something called a backdoor Roth IRA. Backdoor Roth IRAs essentially involve a conversion from a traditional IRA to a Roth IRA, since the traditional IRA has no income limit. That being said, this requires some hoops to jump through, and I would speak to your accountant if you make over $135,000 a year. If you make over $135,000 and don’t have an accountant, it would be a good idea to get one.

 

As if the backdoor Roth IRA wasn’t enough, there also exists a mega backdoor Roth IRA. As far as I’m aware, there doesn’t exist an ultra backdoor Roth IRA (yet). The mega backdoor Roth IRA leverages 401k after-tax contributions to increase the amount that can be contributed to a Roth IRA. It’s complicated. Get an accountant.

 

Setting up your Retirement Accounts

 

Setting up these retirement accounts are easier than they seem (except for the backdoor stuff. Don’t do that without an accountant, if I haven’t made myself clear). Increasing 401k contributions usually just involve filling out a form with your employer. IRAs can be started by using an investment management company such as Schwab or Vanguard. 

 

Einstein once said that compound interest is magical, or whatever. He’s kind of right, as Einstein tends to be. Compound interest means that a small difference in principal can lead to a huge difference in results. Tax-advantaged accounts such as the traditional IRA and the 401(k) allow larger principals, and the Roth IRA allows evergreen withdrawals.

 

Leave a comment

Your email address will not be published. Required fields are marked *