Having enough money to retire comfortably is something that most Americans think about on a regular basis. In fact, according to a study conducted by the Transamerica Center for Retirement Studies, nearly 80% of workers believe that they will have more difficulty achieving financial security than their parents’.
But why is that?
Is it because, with high-debt loads and competing financial goals, the deck is stacked significantly higher against people saving for retirement today than in years past?
Maybe.
Could it be government intervention making it more difficult to adequately save for retirement?
That’s certainly up for debate.
I would, however, argue that the cause is something far more innocuous — the overwhelm of choice.
Put a different way, the sheer number of options available to save for retirement can cause analysis paralysis — you know, the state of over-thinking a situation so that a decision or action is never taken.
If you’re a frequent visitor to the site, you know by now that I’m a fan of simple. Yet our government has made saving for retirement incredibly difficult. With all the different types of accounts, and all the rules that go with them, who can keep up?
Take, for instance, one of the more common questions that I receive: Should I do a Roth IRA or 401k?
Although both are options worth considering, the answer isn’t always as straightforward as you might think.
(*In fact, my take on the matter will probably surprise you.)
Before we get into that, let’s first make sure we have a working understanding of the basic tenets of each and what they both entail.
What Is a 401k?
By definition, a 401k is an employer-sponsored deferred contribution retirement plan — named as such because it appears under section 401(k) of the IRS code.
It works like this:
When you start a new job (or during the open enrollment period) you sign up for a 401k plan and choose investment options within the plan. Your employer then takes money out of your paycheck (before income taxes are taken out) and deposits it into your plan.
When you reach retirement age, you can withdraw that money out of the 401k plan, however, those withdrawals are subject to income tax – since the original contributions were untaxed.
Currently, there are no maximum income limits on who can contribute to a 401k, however, an individual can only contribute up to $18,500 to their 401k, and the maximum amount that can be contributed between employer and employee is $55,000 in 2018.
Benefits of a 401k
- Your contributions may result in tax savings during each year you contribute
- Your employer may offer an employer match — which means “free money”
- Since the money you contribute can be taken directly out of your paycheck, it makes saving for retirement a lot easier.
What Is a Roth IRA?
A Roth IRA is a retirement savings account that allows your money to grow tax-free — since it is funded with after-tax dollars.
Here’s a quick rundown of how it works:
With a Roth IRA, you can set up an account with an online broker of your choosing, select the investment options that most align with your goals and risk tolerance, and then directly deposit after-tax money (from your checking account, for example) into the Roth IRA.
Then, once you reach the age of 59 ½ (not sure what’s up with the ½ year??) and have had the plan for five years or more, you can withdraw both your deposits and investment gains completely tax-free.
In 2018, the maximum contribution you could make to a Roth IRA is $5,500 a year — unless you’re age 50 or over, in which case it is $6,500.
However, unlike the 401k, there are income limits on who can contribute.
For example, if you make more than $135,000 individually or $199,000 jointly, you cannot contribute the full amount (and in some cases, you may not be able to contribute at all).
Benefits of a Roth IRA
- Since you are funding your account with after-tax dollars, your eventual withdrawals will be tax-free.
- Your contributions can be withdrawn at any time without penalty (however, you cannot begin withdrawing your earnings before the age of 59 ½ without incurring a penalty)
- You have the ability to choose the broker and individual investment options, unlike an employer-sponsored 401k.
So far, so good…right? Well, yes, if you don’t take into consideration the distribution rules that apply to both options.
For example:
- Withdrawal penalties before 59 ½
- Must take distributions by age 70 ½ (there’s that ½ year again!!)
- You are required to take a certain amount each year per IRS rules
- *Except for Roths – you don’t have to take money out. But you may not have much there as the limits are low.
We just spent more than 500 words explaining the very basics of two types of retirement accounts. This is crazy!
What’s a person to do?
I offer this suggestion: forget these account wrappers altogether and just save and invest as much as you can in a regular investment account.
Sure, it may not be the most ‘industry appropriate’ answer, but it’s hard to argue against the benefits.
Here’s why:
- Your money is not locked up. If you have an emergency, you can take it out for college, first home, or emergency with no worries about reporting anything to the government
- No mandatory distributions
- You pay taxes each year at lower capital gains rates, and if you lose money, you may be able to write it off against income. You can’t do that with designated retirement accounts.
- Simplifies taxes
And I get it, regular (non-retirement) investments accounts don’t come with any inherent tax benefits, which means you’re required to manage your tax liability much more closely. But really, do you think the government is going to give you a tax benefit without taking something else away? Additionally, any interest and/or dividends that you receive will likely be taxable to you in the year in which you receive them. Such is the case if you sell an investment, you will be responsible for taking care of the resulting capital gains tax liability.
However, there are STILL a few things that make taxable investment accounts attractive.
For starters, you can determine when you have to pay taxes on capital gains. That’s because as long as you hold on to a stock or other investment, you don’t have to pay tax on any rise in its value. Instead, tax liability only comes into play when you decide to sell.
You’ll realize another benefit if you choose a losing stock.
If you’ve taken a loss in one particular stock, a regular investment account will let you recognize a capital loss and earn a tax break from it.
This is certainly not the case with a 401k plan or Roth IRAs except in very rare circumstances.
Final Thoughts
Both taxable investment accounts, 401k’s and Roth IRAs have distinct advantages and disadvantages. For example, the tax benefits of a Roth IRA can be very valuable, but the flexibility of a regular investment account can make having both a smart option for many investors.
The choice is yours.
When it’s all said and done, regular saving is the number one predictor of investment success. It’s not the type of account, or tax benefits or market returns. Consistency breeds it’s own rewards, so just start saving and keep at it until your goals are within reach.
Before you go, I want to hear from you!
Leave a comment in the section below with your thoughts on the complexity of retirement accounts in general, and what you think about the (unconventional) idea of saving in a regular brokerage account.
Pathfinder Planning LLC provides personal financial planning advice and asset management for a simple fee to young adults and working families in North and South Carolina through group classes, one-on-one planning, and ongoing advice.
Your Financial Mom blog posts are not meant to be legal, accounting or other professional service advice. Content represents the opinion of the author only. Pathfinder Planning LLC is not responsible for the accuracy or validity of content contained in third-party comments.