The "I'm Bad at Money" Person's Guide to Understanding 401Ks and IRAs
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When I graduated school and started my first job, I had just missed the enrollment period for my company’s retirement plan. I wasn’t disappointed though and didn’t think twice about it. I’d heard that it was important I enroll in a 401K as soon as possible, but I didn’t get why.
I remember thinking, Can’t I just be diligent about saving money and keeping it in a bank account I don’t touch? Honestly, this notion felt better than being locked into contributing a set amount each month or putting away money into an account that I couldn’t touch until retirement.
But you know what I was missing? More money.
Retirement-specific accounts offer a way for you to get more, whether via an employer contribution (matching 401Ks are a thing), tax-deferred growth, or tax-free withdrawals. Each comes with a financial incentive that makes it far more appealing than my initial plan of saving.
But not all of these accounts are created equal. The three retirement savings plans that you’ll hear about frequently are 401K, traditional IRA, and Roth IRA.
When you put money into any of these, it’s invested in an underlying portfolio, typically a mutual fund, which invests in multiple stocks and bonds and is managed by a professional money manager. These funds are usually pretty easy to invest in—no stock-picking necessary, but each is different in how it functions.
These are usually employer-sponsored plans—unless you’re self-employed and sponsor your own. With a 401K, you set aside part of your pay—before taxes come out of your check; often, your employer will contribute.
Let’s say you decide that you’re going to contribute $1,000. If your employer has a matching option, which 42% of companies do, that means, depending on the match offered, they’ll kick in a percentage of $1,000—up to $1,000.
Although the 401K investment is tax-deferred, you’ll pay taxes on it once you withdraw the money in retirement.
Using a 5% growth rate over 30 years, that $2,000 will amount to $8,600 in retirement. So instead of $1,000 you have $8,600. Winning.
Here’s how it would look if you had that same amount in a savings account earning 1% interest:
If your employer doesn’t offer a retirement plan, or you’ve maxed out your contribution to it—up to $18,000 per year—and you still have money you want to invest, you can look to an IRA.
This works like a 401K in that you’re able to invest money, tax-deferred. Investing tax- deferred means you don’t get taxed on your investment until you withdraw it, same as in the 401K.
Let’s again say that you have $1,000 to invest. Since you don’t have an employer contribution, you invest that $1,000 directly into a traditional IRA account. After 30 years at a 5% annual return you have $4,321.
When you decide you want to pull out that money in retirement you’ll pay tax, but you’ve had 30 years of tax-deferred growth. You’d use this account if you think the tax bracket you’ll be in during retirement will be lower than the tax bracket you’re in currently.
If you think you’ll earn less during retirement than you’re currently earning, you’ll likely be in a lower tax bracket at retirement. However, if tax rates increase between now and retirement, you’ll be stuck paying that higher tax rate on your distributions from your traditional IRA.
This works in the reverse of a traditional IRA. You’d pay taxes today, invest the money, and withdraw it tax-free when you’re in your golden years.
So let’s take that $1,000 and pay taxes on it today—say 20%. You’re left with $800 to invest in the IRA. After 30 years, you end up with $3,460. When you want to withdraw that money in retirement you won’t pay taxes, since you paid them before you invested, and what you have in that account is all yours.
Another perk of the Roth IRA is that unlike the 401K and Traditional IRA, you can deduct your contributions early tax and penalty free. The goal is to set aside these funds for retirement, but if you need to withdraw them in a pinch, you won’t get penalized.
While there are nuances about which type of plan you can choose, the bottom line is this: Retirement accounts have advantages that actually do help you earn more money.
To make sure that you’re on the right track, this is a great retirement calculator. And if you really want to up your financial wellness, start listening to a podcast such as Farnoosh Torabi’s So Money. My guess is that the more you educate yourself on this important topic, the more you’ll be inclined to up your investment game.