Born to be Wild - 401(k) And Roth IRA Accounts

Fair warning, this may be the driest post I’ve ever written, so you may want a caffeine boost before you settle in. Exploring the differences between 401(k) and Roth IRA accounts just isn’t exciting. There is a lot of information here, but it’s necessary information, so here we go.

Now that you’ve figured out how much you need to invest each month to fund your retirement (and even if you haven’t), it’s time to figure out what type of retirement plan is best for you. Think of a retirement plan as a container that holds your investments. There are several different container options, each has different rules (who can contribute, how much, etc.,) and benefits (pay taxes now or later), but not all of them are available to everyone. Let’s review.

401(k)

401(k) plans are offered by employers to their employees, that allow you to invest a percentage of your pay before you even see it (which is great if you have a hard time hanging onto money once it’s in your bank account).

The rules:

Contributions are not subject to tax until withdrawn.
Earnings are not subject to tax until withdrawn.
Employers may offer to match part or all of employee contributions.
Personal contributions are capped at $19,500 if you are under 50, but increase to $26,000 (catch-up contributions) over 50 (as of 2020).
Total contributions (employers and personal) are capped at $57,000 for those under 50 and $63,500 for those over 50.
Only the first $285,000 an employee makes is eligible for contributions or matches.
Withdrawing funds early can result in a 10% penalty on those funds, in addition to the taxes that have to be paid on them (some plans allow a loan to be taken out and paid back over a set time period, which are not subject to the penalty or taxes, but may be subject to interest).

Because this plan is tax-deferred, it may decrease your tax liability now, and may save you money on taxes in the future. The thought process is, most people make less money in retirement, so they will fall into a lower tax bracket. Given the state of the world right now, it may not be wise to assume that taxes will be lower when you get to retirement.

Roth 401(k)

Roth 401(k) plans follow most of the same rules as regular 401(k) plans except:

They are not tax-deferred (contributions are taxed upfront)
The earnings from your contributions are exempt from taxes, as long as you do not withdraw them within 5 years of opening the account.
The earnings from your employer contributions are taxable when withdrawn.
Withdrawing earnings either before the 5 year minimum or before 59 ½ will result in a 10% penalty.

Both traditional 401(k) and Roth 401(k) plans count towards the total contribution limit, so if you have both types of plans, the total contributed to both of them cannot exceed the limits explained above.

Roth plans are beneficial if you expect to be paying higher taxes in retirement than you are now.

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Traditional IRA

IRA (Individual Retirement Account) are personal accounts you can create at a bank or investment firm.

The rules:

Contributions can only come from taxable income.
Contributions are not typically subject to tax until withdrawn, unless one of the following applies, which may limit your tax deduction on contributions:
- You earn over a certain amount (https://20somethingfinance.com/traditional-roth-ira-income-limits/)
- You or your spouse has an employer offered retirement plan
Earnings are not subject to tax until withdrawn.
Contributions are capped at $6,000 if you are under 50, but increase to $7,000 (catch-up contributions) over 50, or your total taxable income, whichever is lower (as of 2020).
There are income limits for some people:

Status

Employer Plan?

Income Cap

Married Filing Jointly

Yes

Phase out starting at $104,000 Completely phased out at $124,000

Married Filing Jointly

Only spouse has employer plan

Phase out starting at $196,000 Completely phased out at $206,000

Married Filing Jointly

No income limits

Married Filing Separately

Yes or No

Phase out starting at $0 Completely phased out by $10,000

Single

No income limits

Single

Yes

Phase out starting at $65,000 Completely phased out by $75,000

Withdrawing funds early can result in a 10% penalty on those funds, in addition to the taxes that have to be paid on them (some plans allow a loan to be taken out and paid back over a set time period, which are not subject to the penalty or taxes, but may be subject to interest).

Roth IRA

Roth IRAs follow most of the same rules as the Traditional IRA, with the same exceptions as the Roth 401(k) plan:

They are not tax-deferred (contributions are taxed upfront)
The earnings from your contributions are exempt from taxes, as long as you do not withdraw them within 5 years of opening the account.
The income limits are different:

Status

Income Cap

Married Filing Jointly

Phase out starting at $196,000 Completely phased out at $206,000

Married Filing Separately

Phase out starting at $0 Completely phased out by $10,000

Single or Head of Household

Phase out starting at $124,000 Completely phased out by $139,000

Withdrawing earnings either before the 5 year minimum or before 59 ½ will result in a 10% penalty.

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SIMPLE IRA

SIMPLE (Savings Incentive Match for Employees) IRAs may be offered by companies with fewer than 100 employees, including self employed individuals. They are less expensive to maintain and require less paperwork than 401(k)s, so they can be more attractive to smaller companies.

The rules:

Contributions are not subject to tax until withdrawn.
Earnings are not subject to tax until withdrawn.
Personal contributions are capped at $13,500 if you are under 50, but increase to $16,500 (catch-up contributions) over 50 (as of 2020).
Employers are required to either:
- Match of up to 3% of the employees salary at 100%
- Contribute 2% of the employees salary, up to $5,700.
Withdrawing funds early can result in a 10% penalty on those funds (unless you qualify for an exemption), in addition to the taxes owed on them (this penalty will increase to 25% if the withdrawal is within 2 years of starting the plan).

SEP IRA

SEP (Simplified Employee Pension) IRAs are employer offered plans, most often used by self employed people.

The rules:

Contributions are not subject to tax until withdrawn.
Earnings are not subject to tax until withdrawn.
All contributions are provided by the employer (employees cannot contribute) and may change from year to year.
Contributions are capped at $57,000 or 25% of your pay, whichever is lower.
Withdrawing funds early can result in a 10% penalty on those funds (unless you qualify for an exemption), in addition to the taxes owed on them.

The following withdrawal rules apply to all the plans above:

Withdrawals can start at 59 ½ (unless, in the case of employer offered plans, you are still working for the company through which the plan was offered).

The following withdrawal rules apply to all the plans above except the Roth IRA:

Withdrawals must start at 72 (as of 2020) (unless, in the case of employer offered plans, you are still working for the company through which the plan was offered). The minimum amount of the withdrawals (RMD – Required Minimum Distribution) is based on how old you are and increase as you get closer to life expectancy (it’s slightly different if your married and there is more than a 10 year age difference between you and your spouse). Penalties apply if the minimum distribution is not met.

Comparison Chart

401K

Roth 401K

Traditional IRA

Roth IRA

SIMPLE IRA

SEP IRA

Employer or Personal

Employer (including self employed)

Personal

Employer

Employer (including self employed)

Personal Contributions Taxed?

Yes

Employer Contributions Taxed?

Yes

Distributions Taxed?

Yes

Earnings on employer contributions are taxed when withdrawn, all contributions and earnings on personal contributions are not taxed (see Penalties)

Yes

No (see Penalties)

Yes

Personal Contribution Cap

Under 50 – $19,500 Over 50 – $26,000

Under 50 – $6,000 Over 50 – $7,000

Under 50 – $13,500 Over 50 – $26,500

Total Contribution Cap

Under 50 – $57,000 Over 50 – $63,500

See above

Match 3% employee contributions at 100% or 2% of employee salary capped at $5,700

Up to 25% of income up to $57,000

Income Cap

No cap, but only the first $285,000 earned is eligible for contributions and matches

None

See chart above

None

Qualified Distribution Age

59 ½ unless still employed by the company who sponsors the plan

59 ½

59 ½ unless still employed by the company who sponsors the plan

Required Minimum Distribution (RMD) Age

72 unless still employed by the company who sponsors the plan

None

72 unless still employed by the company who sponsors the plan

Required Minimum Distribution (RMD) Amount

Percentage determined by age, relative to life expectancy

Loans?

Available from some plans

Unqualified Distribution Penalties

10% plus taxes owed

10% plus taxes (taxes will be assessed on all earnings that are removed early or if the account is less than 5 years old)

10% plus taxes owed

10% plus taxes (taxes will be assessed on all earnings that are removed early or if the account is less than 5 years old)

25% plus taxes owed

10% plus taxes owed

Phew! Still with me? Good.

Weigh your options and decide which plan is best for you. You may choose more than one.

If your employer offers a retirement plan, I suggest starting there, especially if, and I cannot stress this enough, your employer offers a match of some kind. An employer match is free money. For example, my employer will match the first 3% of my paycheck that I put into to my 401(k) at 100%, and match the next 2% I put in at 50%. That means for every 5% of my paycheck that I contribute, they contribute another 4% of my paycheck. That works out to an 80% increase in what is getting invested into my 401(k) – for every $100 I put in, they put in $80. Do you know where you get an 80% return on your money? Fucking nowhere.

This is where I veer from our previous advice about topping off your emergency fund first. If you get an employer match for a retirement fund, contribute enough (if you can) to get the entire match your company is offering. It’s Free. Fucking. Money.

And that shit compounds.

Kat

401(k)

The rules:

Roth 401(k)

Traditional IRA

The rules:

Roth IRA

SIMPLE IRA

The rules:

SEP IRA

The rules:

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