Totally confused about all those retirement terms? Feeling out of the loop? Let’s fix that…
Starting to save for retirement can feel a little like trying to learn a new language. There are so many terms that you’ve never heard of before, and honestly, it gets confusing.
It took me a few years to truly understand the differences between a 401(k) and an IRA (and the difference between traditional and Roth accounts).
I would bounce between articles online that only described one or two retirement terms. I just wanted someone to dumb it down for me – and in one article. Well, that’s what I’ve done for you. Read the quick definitions first, and then check out the Venn diagrams (yup, going to a 3rd grade level here). I want these descriptions of retirement savings plans and terminology to be as simple as possible.
The Shortest Explanation of Retirement Terms Ever:
(Contribution limits are for the year 2020)
401k: you can contribute up to 19,500/year to this retirement savings plan (or $26,000/year if you are older than 50). Your employer sponsors this plan, so you sign up for this at work; your employer may match some of your contributions. There are no income limits to this plan; you can contribute to either a traditional 401k or Roth 401k no matter how much you make.
IRA: you can contribute up to $6,000/year to this retirement savings plan (or $7,000/year if you are older than 50). IRA stands for Individual Retirement Account – the key word is individual, so YOU sign up for an IRA at a bank, credit union, or private company like Fidelity or Vanguard. There are no income limits for contributing to a traditional IRA, but there are income limits for contributions to a Roth IRA (income limits found here).
Traditional: you can have a traditional 401k or a traditional IRA. The term traditional means that the money you put into the retirement account has NOT been taxed yet; you are putting in tax-deferred money. Since you did not pay taxes when you put the money into the account, you must pay taxes on all of money when you take it out (withdraw). All withdrawals are taxed; this includes the money you originally put in AND the earnings (earnings are the money that your original contribution made as a result of being invested in the stock market).
Roth: you can have a Roth 401k (not very common) or a Roth IRA. The term Roth means that the money you put into the retirement account has already been taxed. All the withdrawals (all the money you take out when you retire) are tax free (you don’t have to pay taxes on any money you take out). That means you don’t have to pay taxes on any of the earnings (earnings are the money that your original contribution made as a result of being invested in the stock market) – no taxes on your earnings is the major benefit of a Roth 401(k) or Roth IRA.
So, to summarize in picture form, here are two Venn diagrams of the similarities and differences of 401(k)s vs. IRAs and traditional vs. Roth accounts (temporarily removed so that it can be updated for year 2020).
Which plan is right for you?
Now all of this information is great, but how do you know which retirement savings plan is right for you? I can’t answer that question for you because I don’t know your exact financial situation. However, I can tell you what I do for retirement savings, and my thought-process. It may help you evaluate your situation.
From this article, you know that there are four main types of retirement savings plans: traditional 401(k), Roth 401(k), traditional IRA, Roth IRA.
Traditional 401(k): My employer offers a 5% match – this means that if I contribute 5% of my salary to my 401(k), my employer will also contribute that same amount (5%). What a deal! That’s essentially a 5% raise. I always contribute at least 5% of my salary to my traditional 401(k) to take advantage of this match. After funding my second priority (fully funding my Roth IRA, if you read below), I then contribute as much as I can to my traditional 401(k), above and beyond the initial 5%. I try to contribute up to the maximum, which for me is $19,500/year.
Roth IRA: After contributing the initial 5% to my 401(k) (because my employer matches 5%), I fully fund my Roth IRA $6,000/year. There are a few reasons that contributing to a Roth IRA is my second priority: I am very young, so all of the earnings I make over the next 30+ years until I retire will not be taxed (I should have a lot of earnings because my money has so much time to grow); my earnings will be taxed in my traditional 401(k). Also, if I’m being honest, having a mix of traditional and Roth accounts makes me feel comfortable and I like that I’m taking advantage of both tax benefits that the government offers for retirement savings. I will say that I initially started contributing to this account because I thought I was currently in a lower tax bracket than I would be in retirement. This means that I’d pay less taxes on my contribution now that I would if I were to withdraw the money when I retire (plus, all the earnings won’t be taxed). I opened up a Roth IRA at Fidelity and I have tons of options on how to invest (individual stocks, mutual funds, etc). I am still able to fully fund my traditional 401(k).
Roth 401(k): My employer does not offer a Roth 401(k), so I am not able to contribute to one.
Traditional IRA: I do not have a traditional IRA. I prefer to contribute any pre-tax (“traditional”) money to my 401(k) at work – it’s very easy since the money is taken directly out of my paycheck. Also, my traditional 401(k) has very low administrative fees; I would not be able to find a lower or comparable administrative fee if I opened up my own traditional IRA.
All of the money in my retirement savings is invested in the stock market.
Saving for retirement is important!
Saving for retirement is very important. Why? You’ll need money when you retire (for food, utilities…vacations!). After you retire, you won’t have an employer paying you a salary.
It’s also very important to learn about the different types of plans out there, so you can take full advantage of the tax-benefits that certain plans offer.
Have you starting to save for retirement? How did you decide which retirement savings account(s) was best for you?
Thanks. Very precise. Extremely helpful for a novice like me
Can you do a Roth 401k if you’re self employed/sole proprietor?
It would be great if the Venn diagrams were placed back in the article. I teach college and often the diagrams are the only thing that help it “click” for them. Many of them are visual learners. Waiting …