401(k) vs IRA vs Roth IRA: Millennial’s Guide To Retirement 2018

Hello, Brainiacs!

This week we will be discussing the differences between various retirement plans available to us Millennials.  We will discuss what the best plan is to achieve FIRE (Financial Independence Retire Early), and show how saving even a little goes a long way.

More specifically, we will be talking about a 401(k) vs IRA vs Roth IRA and their benefits as well as disadvantages.  No financial independence or FIRE plan is complete without a retirement plan, but what exactly are these plans?

What are the differences between a 401(k), IRA, and Roth IRA?

Topics

  1. What is a Retirement Plan?
  2. What is a 401(k)?
  3. What is an IRA?
  4. What is a Roth IRA?
  5. How do distributions work?
  6. 401(k) vs IRA vs Roth IRA Comparison Chart
  7. Retirement Account Limitations
  8. Which retirement plan is best for me?
  9. How do I sign up for one?
  10. Finish

What Is A Retirement Plan?

A retirement plan is a method of saving money with the purpose of deferring tax or avoiding tax altogether for when you retire. 

To put it more simply, it is an account you put money into, similar to a bank account.  This money then gets invested in the market.  Depending on the type of retirement plan you have determines when you pay tax, if any, on the gains. 

The keyword here is that retirement plans are a method of saving money.  What I am saying is, you need to save money for them to work. I highly recommend you read one of my previous posts first, Here’s Why You Will Be Working Forever.  More specifically, the concept of “paying yourself first”.

Now that you know the basic idea behind a retirement plan, let’s move on to what the different types of retirement accounts are. 

First, we will explain what each type of plan is, then we will compare them all and discuss which is best.

What is a 401(k)?

Let’s start with the basics of a 401(k). 

This type of retirement plan is named, quite literally, after the IRS code section that defines it

These types of plans have an annual contribution limit of 18,500 as of 2018.  However, if you are over 50 you can contribute an additional 6,000 called a ‘catch-up’. 

A 401(k) is only available through an employer and is sometimes referred to as an “employer sponsored plan”.  If you are currently employed and your employer offers a retirement plan, it is likely a 401(k).  Typically, your employer’s brokerage will handle the investing side of things, you just need to supply the funds.

One of the most notable benefits of a 401(k) plan is that money you contribute is pre-tax

What does this mean exactly? When you receive a paycheck you probably have noticed that federal, state, and payroll taxes get taken out.  These taxes are based on how much of your salary is ‘taxable’. 

If you sign-up for a 401(k) plan, however, and contribute money, you get to save and invest money before it gets taxed.

I Don’t Get It, Show Me An Example

To help visualize the tax saving benefit of a 401(k), here is an example with numbers. 

Say you make $1,000 per week, that is $52,000 per year.  This would mean that approximately 20%, or $200, of each of your paychecks goes towards paying federal taxes and payroll taxes, leaving you with a net of $800 ($1000 – $200).

$52,000 Annual Salary with NO 401(k) Pre-tax contributions
$52,000 Annual Salary with NO pre-tax contributions

Now let’s say you decided you want to contribute $100 every paycheck to your employer sponsored 401(k) plan. 

Instead of being taxed on 20% of $1,000, your rate is adjusted to approximately 18% of $1000, or $180.  The lower tax rate in the following image corresponds to the $100 in reduced taxable income.

$52,000 Annual Salary WITH Pre-tax 401(k) contribution of $100
$52,000 Annual Salary WITH Pre-tax contribution of $100

By contributing to the plan pre-tax, you effectively get to invest an additional $22 each paycheck ($126 – $104).  While that might not sound like a lot, $22 each week for 52 weeks is $1,144 per year!

Note: These numbers are approximate. For simplicity, this does not include state taxes as they vary by location.  Your tax savings will actually increase even more when you consider the state and local taxes you aren’t paying.

Source: https://smartasset.com/taxes/paycheck-calculator

Wait, It Gets Better.

Guess what, Brainiacs — It gets better! 

For starters, your employer likely offers some kind of contribution matching.  401(k) contribution matching basically means that your employer will give you additional tax free money when you make a contribution.

Your employer match will vary by employer, but a common example is 100% of the first 6%. 

In English now — your employer will give you a 100% match for every dollar on the first 6% of your gross salary that you contribute.

Let’s continue with the example above — say you make $52,000 per year.  6% of that is $3,120. 

If you were to make a $100 per paycheck contribution each week, that is a total of $5,200 in contributions per year. 

Well, guess what, your employer just gave you an additional $3,120 in FREE money

Did he just say free money? I think he just said free money.

-You

Yes, FREE money.  Not taxed. Didn’t work for.  Just free money because you decided to save for your future.  Look at you go!

Your $5,200 contribution just turned into $8,320.  You saved $1,144 in taxes, and you managed to save a whopping 16% of your gross salary and barely did anything! 

Take a look below to see what would happen if you simply contributed that same $5,200 per year with and without employer matching.  Assuming you received a 5% raise each year (increasing your match!), your savings would grow over $17,000 more with matching.

401(k) Employer Matching Comparison
401(k) Savings Comparison with and without employer match.  Assumes 5% annual raise.

Additionally, the employer match does not count towards the annual limit and is not taxable when received.  Therefore, with a $52,000 salary you could potentially save up to $21,620 per year in your 401(k)!

A 401(k) sounds great! But what are my other options?

What is an IRA?

An IRA, also called a traditional IRA or individual retirement account, is slightly different than a 401(k)

For starters, an IRA does not require that your employer sponsors the plan.  Therefore, anyone is allowed to open up an IRA account, even if your employer does not offer any retirement plans. 

One caveat though is in order to contribute to an IRA you must have what they call earned income

What that means, basically, is you must be working for your money.  The opposite of earned income would be passive income, such as dividends, capital gains, and interest.  You did not need to actually work to receive these.

Similar to a 401(k), money is contributed pre-tax to an IRA.  The annual contribution limit for 2018 on an IRA is $5,500, and $6,500 if you are over 50.

IRAs are mostly “self-directed”, meaning you are in control of where, when, and how the money gets invested.

If this doesn’t sound like your cup of tea, fear not.  Banks or the brokerage house in charge of your IRA will typically offer advice or a service where they will invest the money for you, for a fee, of course.

Since we are trying to achieve financial independence and retire early, we are trying to minimize our expenses.  While something as small as 1.5% in fee’s may not sound like a lot of money, you must consider what percentage you are making per year, and the effects of compounding.  In an upcoming article, we will be going over how to manage an IRA and talk about which investments are best.

What is a Roth IRA?

Here’s where it starts getting more interesting!

Remember how a 401(k) and an IRA are pre-tax contributions?  Well, a Roth IRA is the opposite. 

Contributions to a Roth IRA are made after tax.  You are probably asking then, why would you want to have a Roth IRA?

The major benefit to a Roth IRA is that because you contributed post-tax money, all of your gains are tax-free

However, with a 401(k) and a Traditional IRA, all of the distributions are taxable at ordinary tax rates because you never paid tax on the money you put in.

Let’s think about this for a second.

Pretend you have invested $100,000 over the course of several years and your retirement account has doubled in value to $200,000. 

If you were to retire and take out all of your money from a 401(k) or IRA, you would pay tax on $200,000.  If you had all this money in a Roth IRA, none of it would be taxable.  Because of this, Roth IRAs are a powerful investing tool for retirement. 

How do distributions work?

There are a few things you need to know about distributions. 

Let’s start with 401(k)s and Traditional IRAs.  You can not withdraw money from them until you reach age 59 and 1/2, otherwise you will get a 10% penalty.

Once you reach 70 and 1/2 something called a required minimum distribution, or “RMD”, kicks in.

All this means is that you are required to take withdrawals from your retirement account.  The amount you must take is a calculation based on your age, life expectancy, and retirement account value.

There is one special rule with 401(k) plans that is not available with traditional IRAs.  There is something called the still working exception.  This rule let’s you delay the RMD until you retire or leave employment.

Roth IRAs on the other hand have no RMD, in fact, you never have to withdraw any money ever if you don’t want to.  However, on your passing, your beneficiaries are required to make distributions.

At the time of withdrawal your distributions from a 401(k) and traditional IRA are taxable.  However, Roth IRA distributions are not.

401(k) vs IRA vs Roth IRA Comparison Chart

Features401(k)Traditional IRA
Roth IRA
Pre-tax or Post-tax Contribution
Pre-Tax
Pre-Tax
Post-Tax
Annual Contribution Limit (2018)
18,5005,5005,500
Additional Allowed If Over 50 (2018)
6,0001,0001,000
Only Through Employer
Yes
NoNo
What Is Taxed
Distributions
DistributionsContributions
Tax Free Gains
NoNoYes
Required Minimum Distribution?
Yes, at 70.5 (unless still working)
Yes, at 70.5
No

Retirement Account Income and Contribution Limitations 2018-2019

No government sanctioned plan comes without rules and regulations! Let’s see what they are!

Roth IRA

  • For 2018, if you are single and your income is over 120,000, or married over 189,000, your ability to contribute to a Roth IRA begins to phase out. 
  • For 2019 the threshold increases to 122,000 and 193,000 respectively.
  • You can contribute up to $5,500 in 2018, and $6,000 for 2019.
  • If you are over 50 the catch-up amount is an additional $1,000.
  • Between all of your Traditional and Roth IRA accounts, only $5,500 total may be contributed in any year.
  • Must have the account open for a minimum of 5 years to avoid tax on distributions.

Traditional IRA

  • For 2018, if you participate in a 401(k), traditional IRA contributions start becoming taxable rather than tax-deferred once your income is over $63,000 for single, $101,000 for married.
  • Gains on taxable contributions are not-taxed at distribution (based on the ratio of taxed/non-taxed contributions)
  • This income limit is increasing in 2019 to $64,000 and $103,000.
  • You can contribute up to $5,500 in 2018, and $6,000 for 2019.
  • If you are over 50 the catch-up amount is an additional $1,000.
  • Between all of your Traditional and Roth IRA accounts, only $5,500 total may be contributed in any year.

401(k)

  • Contribution limits for 2018 are 18,500 going up to $19,000 in 2019.
  • A catch-up of $6,000 is allowed if over the age of 50.
  • Withdrawing before age 59 and 1/2 will generate a 10% penalty.  You have a 60 day grace period to replace non-qualified withdrawals.

Which retirement plan is best for me?

There is no simple answer for this one.  Please read the next section and understand that the answer is not the same for everyone.

Firstly, if your employer has a 401(k) with a contribution match it is a no brainer.  At the very least, even if it’s only a small amount you can afford, you will want to contribute up to what your employer will match.  It is dollar for dollar free money.  As a result it is the most certain investment you can make — 100% guaranteed money.

Secondly, there is a general rule of thumb when deciding which type of retirement account(s) to use.  If you expect your current tax rate is less than your future retirement tax rate, you will want a tax-free account such as a Roth IRA.

Conversely, if you expect your tax brackets to be lower in retirement, a tax-deferred plan such as a 401(k) or traditional IRA may be better suited for you.

The reasoning is that if you are in a higher tax bracket and have a 401(k) or traditional IRA, you will be eating away at your retirement money through taxes on distributions.

Realistically, you have no idea what your future holds or what tax brackets will be in 10-15 years, let alone the next 30-40 years.  Due to these factors it is best that you start with both a tax-free and tax-deferred plan.  As time goes on you can adjust your contributions as necessary.

But one thing is certain…

Start saving now. Not later. Not in a few years. Heck, not even next month. Now.

The reason “now” is important is because of your friend compound interest.  As ‘My Money Wizard’ demonstrates, compound interest is so powerful he is set for life.

There are also other available mechanisms for retirement such as HSA accounts and “Backdoor Roth Conversions“.  I will discuss these in another article.

How do I sign up for one?

401(k)s are very simple.  You will want to speak to your company’s human resources person. 

Typically, they will ask you to fill out a few forms with your basic information (name, address, social security number).  In addition, they may also ask you for information about a beneficiary, but this can usually be done later on.

You will be asked how much of your paycheck you would like to contribute each pay period.  Before you put a number down, ask if your employer does matching and what that match amount is.  Once you know that, you can appropriately withhold the optimal amount to at the very least get your employer match.

There may be a form asking you specifically which funds you would like to contribute to.  While I couldn’t tell you which to pick, each broker is different, the easiest and safest choice will be anything that says “Index Fund”.  Your choices are not permanent, you will have the option to move your money if necessary.

Traditional IRAs and Roth IRAs are a little different.  These accounts are created by you at the broker of your choice.  Hands down the most popular broker in the FIRE community is Vanguard.  This is because of their very small fees and solid investing.

Finish

Phew, that was a lot of writing.

I truly hope you have learned something after reading this.  I spent a great deal of time writing it and if it makes anything even just a little bit clearer I would be beyond excited! 

If you have any questions, comments, or just want to share something with me, please comment below, write me a message on the contact page, or email me at chris@thesavingbrain.com

Thanks for reading,

Chris

Related Post

Be the first to comment

Leave a Reply

Your email address will not be published.


*