Retirement savings Part 1: The basics

The first step in planning for your retirement is to identify the investment vehicle(s) that work for you. There are specifically designed accounts for retirement savings that offer huge tax advantages as opposed to other generic investments.

401K plans and IRAs are the two most common retirement savings accounts. Before we get into the details of what they are and how they are different, it is important to understand these terminologies:

• Contribution: This is the money that you put into a retirement account
• Distribution: This is the money you take out of a retirement account
• Traditional: When a retirement account is a ‘traditional’ account, it means that all your contributions to the account are tax free. When you make a contribution, you do NOT pay tax on that amount you contributed but when you take a distribution you pay tax on your distribution. This is known as a tax deferred account, as instead of paying tax today you pay tax at a later date
• Roth: When a retirement account is a ‘roth’ account, it means that you make ‘after-tax’ contributions to the account but your distributions are tax free.

Let us consider Darcy and Lizzie both of whom earn 100K$ in 2016. Darcy contributes 5000$ into a traditional retirement account and Lizzie contributes 5000$ into a roth retirement account. In the year 2016, Darcy would pay tax on 95,000$ (his contribution was tax free) but Lizzie will pay tax on 100,000$ (her contribution is after tax)

Let us assume that the 5000$ in the two accounts are invested in an identical way and 40 years later when Lizzie and Darcy are 60+ years old, the savings have grown to 6000$ each and they withdraw all their savings. Assuming they had no other incomes in 2056, Darcy will pay tax on 6000$ (distributions are taxed)but Lizzie does not have to pay tax (tax free distribution)

Darcy paid tax on 95000$ in 2016 and 6000$ in 2056. Lizzie paid tax on 100,000$ in 2016. So who had it better? The answer is, it depends. Their tax brackets in the two years would influence that answer, among other things.

401K plans:

A 401K plan is an employer sponsored retirement savings plan. Basically, employees can contribute some portion of their paycheck into this plan. These contributions can be roth (after-tax) or traditional(pre-tax). In most cases the employer matches some percentage of the employees contribution. For more details on the employer match read this post. Even though the plan is sponsored by your employer, the account is yours and the savings are yours even after you leave you job. When you make a traditional 401K contribution, your W2 (wage and tax statement) will deduct your contribution before arriving at your taxable income

IRAs:

An IRA or an Individual Retirement Account is a savings account that you open on your own to save for retirement. An IRA can be roth (post-tax contributions) or traditional (pre-tax contributions) and as long as you have earned income you can open an IRA account. When you make a traditional IRA contribution, you will have the opportunity to subtract your contribution from your income in your Form 1040.

You can contribute to both an IRA and a 401k account at the same time. You can even have multiple IRAs (roth and traditional) and a 401K simultaneously

Both IRAs and 401Ks are just designated accounts with tax advantages. The savings in these accounts can be invested in many different ways including but not limited to certificates of deposit, bonds, stocks, ETFs etc.

The early withdrawal penalty:

If you take a distribution from your retirement account before the age of 59.5 you will have to pay a 10% penalty. Also in a roth account you will have to pay taxes on any earnings that you had. In Lizzie’s case above she would have had to pay tax on the 1000$ gain (6000–5000) that she made if she had withdrawn the amount before she was 59.5 years old. There are however a few exceptions to this rule; e.g. if you are buying your first home or going back to school and you take an early distribution towards that, this early distribution has no penalty. However it is advisable to not take early distributions from your retirement account unless it is absolutely necessary.