The Simplest Way to Understand Common U.S. Retirement Accounts

This post was written by Lindsey Cassell of A+ Adulthood, where she teaches “adulting” concepts like finances, friendship, and housing in the simplest ways possible.

Introduction

The vast majority of Americans plan to retire one day. And although one of the most common ways Americans save for retirement is through their employer-sponsored 401k, 63% of them don’t understand exactly how it works.

This is a problem. It enables financial institutions to take advantage of people, potentially at the cost of hundreds of thousands of dollars to each individual. It also enables people to blame the education system for their lack of money, and that’s also a problem.

Another problem? Many articles, videos, and guides about saving for retirement assume the average American knows the basics of retirement savings plans. Clearly, they don’t (and that’s totally not their fault!).

In this article, I am going to explain, in the simplest terms possible, how each of the four most common types of US retirement accounts actually work.


Why Should I Use These Accounts to Save for Retirement?

Four words: pay less in taxes.

Taxes are expensive. For example, I pay around 30% of my income to taxes..which means for every 3 dollars I make, about 1 goes straight to taxes. The less you can pay in taxes, the more you get to keep and spend on things that are important to you, like donating to charities, paying for your kids’ education, and actually retiring.

You can save for retirement outside of retirement accounts, but it’s likely you’ll pay more in taxes. The government has very nicely allowed us to avoid paying taxes on some stuff when we save for retirement using these accounts. I’ll explain the tax benefits below, but before we get to that…


Don’t Forget You’re Investing for Retirement!

Most people don’t call saving for retirement “investing for retirement,” even though that’s what it is.

Whatever retirement account(s) you choose, the assumption is that you will be investing the money that’s in them into stocks, bonds, and/or other securities. So when you open a retirement account, make sure you are selecting funds or securities for the money to go into, or else it’s just going to sit there like a savings account and not grow significantly over time.

So let’s get started.



Retirement Account Types

401k

A 401k (or 403b for nonprofit or government institutions, they act the same) is most commonly an employer-sponsored retirement account.

The money that goes into a 401k is pre-tax, and is taxed when you pull the money out of the account. To illustrate this, let’s follow the journey of money in and out of a 401k…

  1. You get paid
  2. The money you put in your 401k goes straight into it, without being taxed
  3. The money grows in your 401k for years and years
  4. When you pull money out of the account, that money is taxed
  5. Then you get the post-tax money

So, money grows pre-tax, and is taken out post-tax.


Advantages of 401ks:

  • Many employers have a 401k match, which means they’ll match the amount of money you put in your 401k up to a certain percentage. For example, if you’re putting away 5% of every paycheck into your 401k and your employer has a 5% match, you’ll be getting double the amount put into your account!
  • If you expect to be in a lower tax bracket when you pull money out of your retirement account, a 401k is a great way to pay less in taxes over time.
  • 401ks have high contribution limits – you can contribute up to $19,500 in a 401k (as of 2020) if you’re under 50, and even more if you’re over 50.


Disadvantages of 401ks:

  • If you expect to be in a lower tax bracket now than when you pull money out in the future, you may end up paying more in taxes. However, we don’t know what tax law will look like when we retire – it always changes. For this reason, I personally have both a 401k and a Roth IRA – yes, that’s possible.
  • Some employers have horrible fund options to choose from – aka ones with high expense ratios. Talk to your financial advisor about how to select the right funds for your retirement account. You may find your employer does not have the best options.


Individual Retirement Account (IRA)

A traditional IRA, or Individual Retirement Account, is something you can open on your own through a provider like Fidelity or Vanguard.

In terms of taxes, it behaves the same as a 401k: pre-tax growth, post-tax take home money.

But in case that still doesn’t make sense, let’s follow the journey of money through a traditional IRA…

  1. You get paid
  2. The money you put in your IRA goes straight into it, without being taxed
  3. The money grows in your IRA for years and years
  4. When you pull money out of the account, that money is taxed
  5. Then you get the post-tax money


Advantages of a Traditional IRA

  • If you expect to be in a lower tax bracket when you pull money out of your retirement account, an IRA is a great way to pay less in taxes over time.
  • You also get to choose your own investments with an IRA since you’re opening the account on your own. Again, talk to your financial advisor and/or do your research on the best low-cost funds or securities to pick!
  • You don’t need a job to open a traditional IRA


Disadvantages of a Traditional IRA

  • The contribution limit, aka the amount of money you can add to the account every year. Between an IRA and Roth IRA (which I’ll get to in a minute), you can contribute up to $6000 per year if you’re under 50, and a little more if you’re over 50.
  • If you expect to be in a lower tax bracket now than when you pull money out in the future, you may end up paying more in taxes. However, we don’t know what tax law will look like when we retire – it always changes. For this reason, many people opt to mix and match their retirement accounts to diversify their tax burden when they retire.


Roth IRA

A Roth IRA is something you can open on your own, too, like an IRA.

A Roth IRA has the same contribution limits as a traditional IRA of $6k between the two accounts, but it behaves kind of “opposite” from a 401k or IRA in terms of taxes.

Let’s follow the journey of money through a Roth IRA…

  1. You get paid
  2. Taxes are taken out
  3. You contribute money to your Roth IRA (post-tax)
  4. The money grows for years and years
  5. When you take the money out, it goes straight to you, no taxes taken out (as long as you don’t pull it out before you’re 59.5!)

Take note of when taxes are and aren’t taken out of your money in a Roth IRA as opposed to a 401k.


Advantages:

  • You get to choose your own investments, like an IRA
  • If you think you’re going to be in a lower tax bracket when you pay into the Roth IRA than when you take out the money, you’ll pay less in taxes. Again, the caveat is that tax law (and your life!) could change at any time, so you don’t know if this will be true by the time you retire
  • You don’t need a job to open a Roth IRA


Disadvantages:


Roth 401k

This is a less common type of employer-sponsored retirement account, but it goes with the pattern I’ve been talking about so I thought I’d mention it!

A Roth 401k combines everything we’ve learned so far.

Let’s follow the journey of money through a Roth 401k…

  1. You get paid
  2. Taxes are taken out
  3. You contribute money to your Roth 401k (post-tax)
  4. The money grows for years and years
  5. When you take the money out, it goes straight to you, no taxes taken out (as long as you don’t pull it out before you’re 59.5!)

As you can see, it’s really similar to the journey of a Roth IRA.


Advantages of a Roth 401k:

  • A Roth 401k has the same contribution limits as a regular 401k: $19,500 for those under 50
  • Unlike a Roth IRA, high wage earners ($139k single, $206k married) can contribute to this account
  • If you think you’re going to be in a lower tax bracket when you pay into the Roth 401k than when you take out the money, you’ll pay less in taxes. Again, the caveat is that tax law (and your life!) could change at any time, so you don’t know if this will be true by the time you retire


Disadvantages of a Roth 401k:

  • A Roth 401k has the same limits on selecting your investments as a 401k, that is: you have more limited options
  • If you think you’ll be in a lower tax bracket when you retire, you may end up paying more in taxes than with a 401k. Again, that’s why many people choose to mix and match retirement accounts to hedge their whatever tax bracket they end up in

And there you have it! Now you know exactly how each retirement account works. All of this information is updated as of 2020, so if you’re reading it later, some of the numbers may have changed, but the basic principles are likely the same.

Happy investing for retirement!



This post was written by Lindsey Cassell of A+ Adulthood, where she teaches “adulting” concepts like finances, friendship, and housing in the simplest ways possible.

Her course, Stressed to Invested: Use money as a tool to live your best life, crush debt, and eliminate money stress, is now open for enrollment. Learn more here. (Disclaimer: The conent of the referred website only belongs to Lindsey. Manage-your-Money.com is not responsible for any links or content within the referred website.)

*Invest at your own risk. This article does not constitute investment advice and is for educational and entertainment purposes only.*

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