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.

Although income tax is more salient, most Americans pay more in payroll taxes. These are the Social Security and Medicare deductions you see on each paystub (a.k.a. FICA or OASDI). Income taxes are progressive, meaning taxpayers pay a progressively higher percentage of their incomes as their incomes increase. Payroll taxes, on the other hand, are regressive, meaning taxpayers pay a flat and/or decreasing percentage of their incomes as their incomes increase. This results in an unusual and unfair phenomenon where 76% of taxpaying Americans actually pay more payroll taxes than federal income taxes.

How do payroll taxes work? A fixed percentage of your gross wages are deducted by your employer each pay period, paid to the federal government. This percentage, as of 2018, is 6.2% for Social Security and 1.45% for Medicare, for a combined total of 7.65%. Many employees do not know this, but your employer also must contribute 6.2% for Social Security and 1.45% for Medicare behind-the-scenes, which is another 7.65% bringing your total tax to 15.3%. This means that when a job is advertised for $10.00 per hour, your employer actually is paying $10.77 per hour if we include their share of these taxes, and even more if we also consider unemployment tax, workers’ compensation insurance, and other obligations. Although payroll taxes do not apply to some employees and employers, such as myself as a Graduate Teaching Associate at University of Central Florida, these exceptions are uncommon.

If you are self-employed, you must pay the full 15.3% of payroll taxes out-of-pocket. This is a shock for many sole proprietors, such as freelancers. The IRS expects tax payments on a quarterly basis, rather than a lump sum after the tax year ends (if you were an employee, they would be getting the money in advance from each paycheck). Your business expenses, such as miles driven in a car, may be deducted to reduce the earned income to which payroll and income taxes apply (keeping excellent records and employing an accountant is recommended).

With income tax, nearly half of Americans get all the money back (or more) in their tax refunds. A good chunk of your income is exempt (the standard personal deduction), and tax credits, most notably the Earned Income Tax Credit, soak up whatever other tax is owed and provide a sizable refund for low- and middle-earning people who have children. This stands in stark contrast to payroll taxes, for which there is no refund. (Except in the unusual case where you had multiple employers and earned more than $128,400 [2018 cap] in combination between them, in which case you can get a refund from the IRS for the excess 6.2% Social Security tax you paid on amounts exceeding $128,400.)

The IRS, as directed by existing laws/regulations and the U.S. Congress, makes an important distinction between earned and unearned income. Earned income consists of typical employment wages, including self-employment, and is subjected to payroll taxes. Unearned income includes bank account interest, dividends, capital gains, and Social Security benefits, which are not subject to payroll taxes. With qualified dividends and capital gains, the income tax rates are lower too; about half that of ordinary, earned income. This is an enormous benefit to investors in equities (stocks), who already benefit from the huge capital gains that equities reliably provide over long periods of time. It’s also an enormous disadvantage to most Americans, who work but do not invest, and is a primary contributor to wealth inequality and disenfranchisement.

Although payment of payroll taxes is compulsory and factors into the amount of Social Security benefits you receive each month in retirement, in a U.S. Supreme Court case from 1960, it was decided that paying payroll taxes does not entitle you to anything. The plaintiff in this case was deported for being a communist, and thus his Social Security benefits were revoked despite having paid payroll taxes for 19 years, which the court upheld.

Nonetheless, most Americans can count on receiving their benefits if they survive to retirement age. However, many caution that the system will become unsustainable by the time today’s emerging adults reach retirement age. But, this is a product of tax policy: Social Security tax unfairly rewards high earners by pulling a vanishing act for wages above $128,400 per year. This means if someone earns $200,000 per year at one employer, the government collects 12.4% in Social Security tax on their first $128,400 in wages, but collects 0% on the next $71,600 of wages. Incredible. We could make Social Security solvent by eliminating the cap. Bernie Sanders suggested raising the cap to $250,000 in wages during his 2016 presidential campaign, which has been criticized as extending solvency only from 2034 to the year 2055, but removing the cap entirely would probably do the trick, while maintaining Social Security’s standing as a regressive tax. It would merely be less regressive than it is now.

With Medicare tax, which is 2.9% divided equally between employer and employee, there is already no cap. In fact, for earned income above $200,000, employees have to pay an extra 0.9%, bringing the total tax to 3.8%, and meaning the Medicare portion of payroll taxes might actually be classified as progressive. As we can see here, if removing the Social Security cap proves insufficient, there is already a precedent for having an uncapped payroll tax that also increases with higher earnings.

Because of the grossly unfair tax treatment that earned income receives, coupled with the power of investing in index funds of the whole stock market and the tax benefits one receives for doing so through lower taxes on capital gains, privileged tax treatment for retirement accounts (i.e., 401[k], 403[b], 457, IRA, thrift savings plans, etc.), and other incentives like the Retirement Savings tax credit, relying only on earned income and savings accounts is pretty much hopeless, if your goal is to achieve financial independence. This is why educating yourself (such as by reading Tippyfi) and improving your financial and investing capabilities sooner, rather than later, is critical.