Wealth Club: Now You Will Understand IRAs

In our financial advice column for the centsless, Michael Fleck fields questions on how to get your money right. Send your queries to wealthclub@goodinc.com.

I’m in my mid-20s. People continuously tell me that I should be putting away money for retirement, but a) it seems way too far away for that, b) I don’t really think I have extra income to put away, and c) have no idea what the difference is between a 401(k) and a private IRA.

I should probably have my father write this column. He could run circles around me explaining this, but I’ll consider this a personal challenge to see how much I’ve actually learned from him. I don’t think it’s necessary to explain to people why it’s so important to save for retirement. Everyone knows that after a certain age, people either don’t want to work, or can’t. Because Social Security can’t cover the wild and crazy lifestyle of most octogenarians I know, it’s extremely important that we have access to other funds while in retirement.

Why start now? For one thing, you capture any potential gains over the next 10 years; and time is one thing you can’t catch up on, no matter how much money you make in the future. Get into the habit of putting money away now: Once you build savings into an already-tight budget, you'll never miss it down the road.

And it’s never been easier to save for retirement. The government certainly wants to help you do it: In 1974, to encourage more people to save for their old age, a federal law called the Employment Retirement Income Security Act created Individual Retirement Accounts. IRA is a very broad term that covers basically any investment vehicle that provides you tax savings to put away for retirement. There are multiple types of IRAs, but in the interest of making this more digestible, I’ll limit my discussion to traditional IRAs, Roth IRAs and 401(k)-type IRAs.

In the traditional IRA, most taxpayers can elect to put up to $5,000 into an IRA annually ($6,000 if you’re over 50), and deduct that from their taxable income. This is akin to any pre-tax items taken out of your paycheck on a monthly basis, like health care flex benefits. Instead of paying now, the income tax is due when you withdraw money in your golden years (that is, after age 59 ½). The immediate advantage is the ability to reduce your taxable income this year—not a bad deal. However, if you take money out of the Traditional IRA before you hit 59 ½, you will not only have to pay taxes on it, but you'll also be subject to a 10 percent early withdrawal penalty. There are some exemptions, however: If you’re using the money to buy your first home, or to pay for certain education expenses for you or your family, you may avoid the penalty.

In 1997, a new type of IRA was introduced: The Roth IRA, named after five-term Senator William V. Roth, Jr. (R-Delaware). The main difference between a Traditional IRA and a Roth IRA is that contributions are made with post-tax money. There is no immediate tax advantage, but when you start withdrawing at 59 ½, you won’t be taxed at all. Another great feature of the Roth IRA is that all contributions can be withdrawn at any time with no tax or penalty. If you start your Roth with $2,000, forget about it, and 10 years later it’s grown to $10,000, you can take back that original $2,000, no questions asked—you already paid the income tax on that sum. If you want to take out all $10,000, and you do not qualify for a penalty exemption, you will owe both income tax and a 10 percent penalty on the other $8,000. I’d never advocate taking money from your retirement without very good reason, but it’s nice to know that whatever you originally contribute to your Roth can be thought of as an emergency savings fund.

The distinction between the two is tax-deferred growth—a traditional IRA lets you push your tax bill down the line, while a Roth IRA makes you pay taxes on your principal, but everything thereafter is tax free. Why wouldn’t everyone choose a Roth IRA over a traditional IRA? Due to certain income limits, not everyone can. In 2012, individuals making more than $125,000 cannot contribute to a Roth IRA account… #notaproblem. There are also a few very specific cases where it may be more advantageous to opt for the traditional IRA, but suffice it to say, for most GOOD readers—especially younger people who currently have little to no retirement savings—the Roth IRA is preferable to a traditional IRA.

The hardest part of the IRA decision-making process is where to open your IRA, and what to invest in. The big three firms, which can offer personalized guidance and a variety of investment options are T. Rowe Price, Vanguard and Fidelity. Discount brokerages, such as Etrade, Scottrade and Ameritrade, will also offer a variety of investment choices, and possibly lower fees, but less-personalized service. Lastly, there’s a good chance your current bank or credit union can offer you an IRA. This may be an attractive option if you know and trust your current bank. Be careful though, you may be much more limited in what you’re allowed to invest in. All of these institutions have advantages and disadvantages, so call around, ask questions and tell them what you’re looking for. People will be friendly—they’re trying to sell you something.

A 401(k)-type plan is an employer-sponsored retirement plan that operates similarly to the traditional IRA. As 401(k) plans grew in popularity in the 1980s, pension plans became much less common now than they were years ago, and the burden of retirement savings has been shifting from the employer to the employee. Like in the traditional IRA, contributions are made on a pre-tax basis. The main advantage to this account is the fact that most employers offer some type of match, based on what percent of your salary you contribute, in order to incentivize saving for retirement. A typical match might be “50 percent of employee’s election, up to 3 percent.” This particular match yields the following table:

Wealth Club Rule: If your employer offers a 401(k)-type plan with a match available, you must participate, at least up until you’ve maximized the match. People, I’ve said it before: This may be the easiest, most legal way to receive FREE MONEY. Be aware that some employers have a vesting period, where their match only becomes yours once you’ve worked there for a pre-determined period of time, but unless you’re absolutely sure you won’t be at that job for more than the vesting period, it makes no sense not to participate. If your employer does not offer a 401(k)-type plan, and you want to start saving for retirement, the Roth IRA is most likely your best option.

Now, to put the financial cherry on the top of our retirement ice cream sundae, let me briefly touch on a recent development: the creation of what’s called a Roth 401(k). Yes, it’s as delicious as it sounds, because it combines the best of both worlds. It’s an employer-sponsored account that’s funded with post-tax dollars, so you get the tax benefits of a Roth IRA without the income and contribution limits. Furthermore, employers can still make matches; but these funds must sit in a separate, pre-tax account that will be subject to the same taxation treatment upon retirement. The Roth 401(k) is not yet widely used, but keep it in the back of your mind if you find yourself in a job that offers it.

Hopefully this gives you at least a basic understanding of how we’re allowed to save for retirement and the benefits of doing so. See you in 2050!