The following is adapted from One Decade to Make Millions.
Since I entered the investment business shortly after college, I got comfortable with the idea of just leaving my money invested in stocks. I stayed invested through some scary market events and enjoyed nice gains during some big rising markets.
But after forty years in the workforce, my largest pool of investment money is in retirement accounts: my IRA and 401(k). In fact, this is where most working people build up their largest investment accounts.
You have probably heard the terms “IRA,” “Roth IRA,” and “401(k)” and know what these investment tools are and how they work. But you may not know everything you need to know about these incredible wealth-building accounts.
Following is a general overview of retirement accounts to offer you everything you need to know about investing for your future.
Track all your accounts in one place. IRAs, Roth IRAs, 401(k)s, brokerages, savings, and more.
A traditional IRA
IRA is an acronym for “individual retirement account.” You put money into this account, and the contribution is tax-deductible. The contribution lowers your taxable income and therefore reduces your tax payment in the year of contribution. This is the first tax advantage.
Because of the income tax deduction, it reduces the amount of out-of-pocket contributions you must make. Say you deposited $6,000, the maximum allowed contribution for 2022, in your new IRA and that you are in a 20 percent income tax bracket. The $6,000 deduction reduces your income tax by $1,200 that year. Your net out-of-pocket cost after tax is $4,800, but you have $6,000 that goes to work and can remain invested for many years!
The interest or gains in this IRA are not currently taxable, which is why retirement accounts are often referred to as tax-deferred accounts. This is a second and very important advantage. There is also a drawback, however. If you withdraw money from this account before age fifty-nine and a half, you must pay tax on the withdrawal plus a 10 percent penalty.
Money you put into an IRA is meant to be a long-term investment that you should not need to touch until your retirement years. Some exceptions allow for a penalty-free early withdrawal. When you quit working, the money that has accumulated is then taxable as it is withdrawn.
A Roth IRA
The Roth IRA is very similar to and very different from a traditional IRA. It’s set up just like the traditional IRA, and investors can make annual contributions of up to $6,000 into a Roth IRA. However, the contribution is not deductible for tax purposes. The accumulated earnings inside the account grow without current taxation. But when you withdraw money from the Roth at retirement, there are no income taxes on the original contribution or the years of accumulated earnings from interest, growth, dividends, and so on.
This can be very attractive for young investors who are not in highly taxable situations. The tax deduction may be relatively unimportant to them and the money can then be left to multiply for many years in growth investments.
To summarize, in some ways a traditional IRA and Roth IRA are opposites. Traditional IRA contributions are tax-deductible, while Roth IRA contributions are not deductible. Traditional withdrawals are fully taxable, while Roth withdrawals are generally not taxable.
A 401(k) Plan
The 401(k) is set up by the company, and your contributions are made through paycheck deductions. It’s a great way to save because it goes into retirement investments before you can even be tempted to squander it! Typically, the investment choices are available as a menu of multiple mutual fund accounts from which you can select.
The 401(k) maximum contribution for 2022 is $20,500, plus an additional $6,500 “catch-up” contribution for plan participants over age fifty. The maximum contribution limits are updated annually. If you want to maximize retirement savings in 2022, put away $6,000 in an IRA and $20,500 in a 401(k) for a total of $26,500 per year—and up to $33,000 if you are age fifty or older and IRA eligible. Remember that the amount you save is for retirement, so early withdrawals are usually subject to penalties.
However, company plans often have a loan provision through which an employee can borrow money from their plan to meet a need, usually up to $50,000. You can pay this loan back to yourself with interest. The 401(k) plan can be pre-tax like a traditional IRA or it can be an after-tax contribution like a Roth IRA if your company plan provisions allow after-tax contributions.
Retirement account advantages
Most people who make a living by working for someone else have their money in retirement accounts, and they are making the most out of their finances. The reasons are:
- One hundred percent of the money saved to the account (income taxes are not withheld from contributions) gets invested and put to work.
- The growth, the dividends, the interest, and all the returns compound without taxation until they’re withdrawn.
- Because there is a 10% penalty if you were to withdraw funds prematurely, you won’t spend any of the money.
- If you always maximize your contributions as you progress in your career, you can take advantage of larger and larger contribution opportunities.
This is a very general overview intended to help you begin using these very important types of tax-advantaged accounts. Retirement accounts are a good start to a steady savings plan if you contribute every time you get a check and enjoy tax advantages while saving for your future.
