Investing for Retirement

Should I invest my Roth or IRA first? Also what’s a 401(k)?

These are all accounts you invest in during your working years and spend during your retirement years. The main difference between them is when taxes are paid. Traditional IRAs and 401(k)s are tax deferred accounts while Roth IRAs and 401(k)s are tax free accounts. The type of tax we’re talking about here is income, or ordinary tax (what you pay as a percentage of every paycheck). If you’re already familiar with these accounts and just want the quick and easy optimization techniques, see below:

  • If you are in your early income years and think you’ll be living on a higher dollar amount in retirement, then pay taxes now and contribute to a tax free account

  • If you think you’re earning more now than what you’ll be living off of in retirement, contribute to a tax deferred account

  • If your employer provides a matching incentive, then contribute to your 401(k), at least up to their matching limit

  • If your employer doesn’t provide a matching incentive, then contribute to your regular IRA/Roth first and then anything in excess of the contribution limit to your 401(k). This is mostly just to alleviate administrative burdens later when you change jobs and/or want to transfer your 401(k) or want to rollover your 401(k) to your IRA. Especially recommended if you don’t think you’ll be contributing more than the IRA/Roth IRA limit each year. If you make more than $74,000 (as of 2020), your contribution deduction to a traditional retirement account is phased out so you’re better off just contributing to your 401(k).

That’s it from a general sense. Pretty simple, right?

Although these accounts are meant primarily for retirement planning, they have a lot more potential in your financial plan with respect to passing assets down, charitable giving, and tax mitigation. Before you do anything, consult with your financial advisor as there are large consequences for mistakes.

Hopefully this provides some comfort and/or next steps for you. Leave a comment and subscribe!

Just some more detail below on the main differences between these accounts:

Tax deferred means you pay tax the year which you take a distribution from the account and fund the account with pre-tax dollars. The pre-tax benefit is why they’re so appealing because they allow you to use a larger portion for yourself instead of it giving it away to taxes. This benefit is also advantageous because it allows for more control in the timing of taxes due and the taxable rate.

Tax free means no taxes on withdrawals (including all investment growth) because you have to fund the account with after-tax money (the portion of your paycheck that actually hits your bank account). Now assume you stay at the same income level, spend at the same rate, and your marginal tax rate remains the same for your entire life. Theoretically, there would be no net value difference in an IRA or a Roth IRA. Real life isn’t that simple though and there’s a time to use each.

A 401(k) can be tax deferred (traditional 401(k)) or tax free (Roth 401(k)) and are set up through your employer. The difference with the 401(k) tag is how much (determined by the IRS) you’re allowed to contribute in a given year. In a regular IRA or Roth IRA, you’re allowed to contribute up to $6,000 (combined, not each) while you can contribute up to $19,500 in your 401(k) in 2020. You can contribute to a 401k and an IRA/Roth account for a combined limit of $23,500 in 2020. Those that are over 50 can contribute a little more with catch-up contributions. All these limits are usually adjusted slightly upwards each year to account for inflation.

401(k) accounts have another advantage because employers will generally match (up to a certain limit) how much you contribute as an employee benefit. Most of these matches are up to 3% (check with your employer), which means if you contribute 3% of every paycheck, your employer will put in the same dollar amount for your benefit. That’s free money you’re missing out on by not contributing anything in your 401(k).

Which one is better: tax deferred accounts or tax free accounts? Well it depends on you. Refer back above to the optimization scenarios and select the option that best suits your scenario.

Compliance stuffs
Just remember, I’m not your financial advisor so the information may or may not best apply to your situation and you should get formal advice prior to doing anything. The information/data that is shared should be double checked by you and any conclusion that is driven based on past data is not to be interpreted as my advice for your future. I will do my best to only write what I think is true and right, but mistakes happen and we’re all learning together – this is meant to be a conversation.

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