Tippy sleeping

Like Tippy, pictured above, most people would sooner fall asleep than read about different types of retirement accounts. However, they are vital to well-funded retirement and can save you money, too.

The individual retirement arrangement (IRA) is an account you set up on your own at a brokerage such as Vanguard, Fidelity, or Schwab, or at a bank such as Ally. Any American with earned income can contribute to one (even minors), and one can have both an IRA and a 401(k). The investment options are wide open; your choices range from investing in an index-tracking mutual fund of the whole U.S. stock market, as I recommend on this website, or something as safe as certificates of deposit (CDs), which presently pay 2–3% each year without risk of losing money.

IRA contributions come out of your bank account without involvement of your employer. Like 401(k)s, IRAs function as commitment devices, penalizing you for withdrawing money before Age 59 and 1/2. Like 401(k)s, they also offer tax benefits, although a key difference is that with IRAs, these benefits are restricted to people earning under approximately $125,000 per year.

In contrast to IRAs, 401(k)s are employer-sponsored. Your employer offers instructions on how to set up an account (perhaps on their website, Intranet, or at the HR department). The investing options are more restrictive than with IRAs, although usually there is at least a low-cost S&P 500 index fund available. You might be compelled to use a particular brokerage, such as Fidelity or Prudential. With 401(k)s, you must direct your employer to take money out of each paycheck to contribute.

The key benefit of a 401(k) is an employer matching contribution. About 4 in 5 employers offer to match a portion of employee contributions, which is free money. For example, some employers will match up to 100% of up to 5% of each paycheck. If your gross wages are $2,000 every two weeks, this means if you contribute 5%, or $100 of each paycheck to your 401(k), your employer contributes $100 per paycheck as well. This is like giving yourself an instant raise. Even if you have credit card debt to pay off, an employer 401(k) match should be prioritized first.

For teachers and certain other nonprofit employees, the 403(b) replaces the 401(k) but is basically the same. The Thrift Savings Plan for federal employees also functions similarly.

IRAs and 401(k)s are both offered as “traditional” and Roth versions which is the difference between being taxed when withdrawing the money in retirement (“traditional” version), or now, in the current tax year (Roth version). Generally, Roth contributions are preferable if you are in a low tax bracket now, because income tax works on a year-to-year rather than cumulative basis.

With 401(k)s, it is still somewhat rare for employers to offer the Roth option. Traditional contributions are useful if your income is a bit higher, both for lowering taxes and for lowering your income to qualify for child tax credits, Health Insurance Marketplace subsidies, et cetera.

Retirement contributions offer another tax benefit: you may also qualify for the Retirement Savings Contributions Credit, which can be worth over $1,000. Unlike with most 401(k) plans, you can make an IRA contribution for the 2018 tax year up until April 15, 2019. However, you should make 2018 contributions to your IRA before filing your 2018 tax return; otherwise you would need to file a superseding or amended return to claim the saver’s credit, and income deduction if making a traditional (not Roth) contribution. When contributing, banks and brokerages will ask you whether you want to designate the contribution for tax year 2018 or 2019.

Many people do not know that you can make contributions to both 401(k)s and IRAs, up to the maximum for each. In 2018, this was $18,500 for 401(k)s and $5,500 for IRAs ($24,000 total), and in 2019, the limits increase to $19,000 for 401(k)s and $6,000 for IRAs ($25,000 total). The vast majority of Americans never get close to either of these limits. Who has $6,000, let alone $25,000, of income to give up in a year? Surveys show about 40% of Americans are hard-pressed to even come up with $400 in a pinch.

Because most people will not approach the limits for either type of retirement account, it is generally fine to have only an IRA if your employer does not offer a match, or to have a 401(k) to contribute only up to the match and then put additional contributions, if any, in an IRA. Americans switch jobs often, particularly among emerging adults, and the plan rules vary widely between employers and 401(k) providers, which makes managing or rolling over orphaned 401(k)s a nightmare.

I have previously characterized retirement contributions as buckets like below, encouraging readers to max out their contributions for each year:

Full retirement buckets

Although this is the fastest path to financial independence, almost no one has the disposable income to do this. Consequently, I recommend paying high-interest debt such as credit cards, private student loans, and unfavorable auto loans before contributing to an IRA. If you have a 401(k) employer match available, this should take priority over high-interest debt, but beyond this, the math favors paying high-interest debt now and increasing retirement contributions later. Full buckets, as pictured above, are unlikely to be a problem.

One of the main goals of my writing is to share and discuss the preparations necessary to be a successful investor—knowledge, emotion, psychology, arithmetic, and more. There will be years like 2002, 2008, and 2018 where you lose tons of money, but on balance, many other profitable years make investing worthwhile over multiple decades. With retirement accounts, it is easier to envision being invested for the long-term because there are penalties for withdrawing money before Age 59.5. In addition, retirement accounts offer tax benefits now, which can make it easier to save or invest for retirement.

You can contribute to an IRA while putting your money in a CD, a completely safe investment with no risk of loss. Some 401(k) plans may also offer safe investments such as U.S. government debt. Within your IRA and 401(k), you are free to move money around between investments at a later time. Therefore, you can start contributing to retirement accounts now, while making risky investments in stocks later, when you are ready—or never.

The retirement accounts established by U.S. lawmakers are labyrinthine and unfortunate. There are many bizarre phenomenon, such as being able to withdraw Roth contributions early without penalty but not traditional contributions, being able to withdraw from your last employer’s 401(k) without penalty if quitting after Age 55 but not from an IRA until Age 59.5, and illogical rules that change year-to-year regarding contribution thresholds and limits. Although you could restrict yourself to taxable brokerage and savings accounts, you must participate in the labyrinth to reap the tax benefits enshrined in U.S. laws and the tax code. Although politicians pretend that retirement accounts benefit the middle class, in practice they benefit the wealthy. Half of Americans do not even have stock investments, which are likely to grow the most over decades (compared with savings accounts, CDs, bonds, etc.) and make the tax advantages of retirement accounts especially profitable. This is one item I and others hope to change through financial education.

Many people don’t even know where to begin when it comes to enrolling in their employer’s 401(k) or 403(b) programs, let alone choosing their investments. Here, I show an example of how one would do this at my employer, University of Central Florida (UCF).

First, you would seek out this one-page guide from UCF and choose one of three investment providers. I prefer Fidelity, which, like the others, has a portal to aid UCF employees in opening their account. After applying for an account at your chosen provider, at UCF you would complete the Salary Reduction Agreement form and submit it to the HR department. Because UCF is a public school (university), the plan is called a 403(b) instead of a 401(k), but is basically the same. When you put money into such plans, you generally cannot access it until Age 59.5 or older without incurring substantial penalties, so you should pay off high-interest debt and have a substantial emergency fund in an FDIC-insured savings account first.

The form, pictured above, has several options. First, you must decide if you want to make pre-tax (traditional) or post-tax (Roth) contributions, or a combination of the two. Generally, low earners should use post-tax (Roth) contributions because they are in a low tax bracket, while high-earners should use pre-tax (traditional) contributions to reduce their present tax burden. Second, you must choose an investment provider. UCF offers Fidelity, TIAA, and VALIC. Personally, I prefer Fidelity from these three, although I would pick Vanguard if it was available.

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