When it comes to retirement, I’m sure you’ve heard all the letters and numbers: 401k, IRA, 403b, TSP, etc. Confusing, right? What’s the best one?
That’s why today we’re going to look at two of the most popular — the 401k and the IRA. We’ll look at the pros and cons of each so you know which direction to go with your retirement savings.
Have you noticed it seems like everyone is like “Oh, save for retirement! You need to get ready for retirement!” It would be a lot easier if you could just throw the money you need in your savings account and be done with it.
Sadly, that won’t cut it.
We’ve got to take advantage of what Einstein called the “Eighth Wonder of the World”: Compound Interest.
This is where if you have $100 invested and you’re receiving a 10% interest rate, you’ll earn $10, totalling $110. Then you’re earning 10% interest on not only your $100 but also your $10. Next time you’ll be adding $11 to your total, bringing it up to $121.
Every year, it gets higher because you’re earning interest on interest!
That’s what your retirement accounts are going to do barring any economic disasters. They’ll use your money in the stock market to increase your rate of return over a normal bank, making that compound interest so, so sweet.
So, let’s get into retirement accounts.
- This is an employer retirement account.
- You can invest up to $19,500 of your income per year straight from your paycheck.
- You can take advantage of an employer match.
- It’s restrictive on where it’s invested as it must be with your employer’s 401k provider of choice.
- You are not able to withdraw with no penalty until you are 59 ½ years old.
- You can invest up to $6000 per year as of 2021.
- You can have a lot of flexibility about where this is invested. Many companies have IRA’s you can choose from like Vanguard and Charles Schwab.
- You can take contributed money out without any penalty before 59 ½. The growth must stay in unless you want to pay a 10% tax penalty.
Roth vs. Traditional
Now, within each retirement account, there are a couple options — Traditional and Roth.
With traditional (in either 401k or IRA), the money that is contributed is contributed pre tax. Meaning, money is pulled out for the paycheck before tax is removed.
With Roth (in either 401k or IRA), the money contributed is done post tax. Meaning, the gross paycheck is taxed, then a part of the remaining amount is invested for retirement.
Just looking at those, you’re like wait, one is taxed and the other isn’t? Traditional is the way to go! Here’s the kicker.
While the traditional 401k or IRA has contributions that are made before taxes are taken out, everything you take out of that account when you retire will be taxable income.
With Roth, your taxes are taken out first then contributions are made BUT, when you retire, EVERYTHING including the growth will be able to be withdrawn from your account TAX FREE.
What does that mean for your money?
This is significant. If you’re about my age and have 40 years of work left before retirement, you can expect about 25% of your end retirement account’s value to be your contributions (using a 6% rate of return adjusted for inflation).
The other 75% is all growth! If you have $1 million by the time you retire and that is in a Roth account whether 401k or IRA, that means the 75% that is growth ($750k in this case) is not taxable.
Versus, if you have $1 million in a traditional account, you have to pay the taxes for your contributions and your growth.
Generally speaking, this is the better option for anyone young to middle age as it can save you thousands if not hundreds of thousands of dollars in taxes.
So what do you think about all this retirement stuff? Maybe a little less confusing now?
Let me know in the comments below! I want to hear about your retirement dreams and goals. I personally want to do some traveling with Bailey. There are a lot of places in this world we have yet to see.
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