Do you know what would be really cool?
If we had just one kind of retirement account with simple rules for putting money in and taking it out. Keep dreaming! We don’t. We have so many different kinds of retirement accounts – all with crazy ridiculous rules, half of which you wouldn’t even believe if I told you. It’s almost as if the geniuses who designed all of these accounts actually didn’t want us to save for retirement. Honestly, I don’t think you could do anything to make them more complicated and less user-friendly.
So what do most people do in the face of mind-numbingly difficult rules and systems?
They read the fine print and rationally weigh pros and cons of each account in a systematic manner aimed at maximizing options and eventual net value? Well, it’s either that, or do nothing and hope for the best.
But not you! You are getting money smart!
Here’s the least you need to know about the most common retirement accounts. Here’s what most of them have in common:
Retirement. They are retirement accounts. This means their purpose is for, you guessed it, retirement. This is money you put away today for when you retire. So they are all really set up for the long-term. They make it hard for you to pull money out before you retire. You might get hit with penalties and other restrictions. Again, it’s called a retirement account for a reason!
Invest. You get to invest this money in mutual funds, stocks, bonds, or other types of investments, if you want. It’s not designed to be a savings account that sits in cash. Since the money is for a far off retirement, you are encouraged to invest it.
Tax. You get to save income tax now. The money you put into the retirement account reduces the amount of money you have to report to the IRS, which means because you have a lower income, you are taxed less. And here’s the catch. Even though you benefit from paying less tax now, eventually, the IRS is going to want their tax. That’s why these accounts are sometimes called “tax deferred.” It means you’re not paying tax on it now, but rather you are deferring it to the future when you take money out of your account. What’s so great about that? Your account gets to grow over the years (and possibly decades) without you having to pay any tax.
Okay, so those are the things that are similar about most of the retirement accounts.
Now let’s break the retirement accounts into two main categories:
Company plans are those offered through an employer. In other words, you have to work for a company to be able to open and save in one of these accounts.
- 401(k). This is the granddaddy of company-sponsored retirement plans. Many employers offer these to their employees. As an employee, you can take some of the income you’d normally get in your paycheck and have it deposited into your 401(k) account instead. So instead of getting $1,000 in your paycheck, you might decide to invest $100 in your 401(k) account, so you’d get $900 as your paycheck. There are a few cool things about 401(k)s. First, you’re able to contribute quite a bit of money each year into it, more than many of the other retirement accounts. Second, some companies will even put some extra money in your 401(k) account for you! This is called a match, and it’s free money to you. you’re
Okay, there are a lot of other retirement accounts through companies such as SEP IRAs, Simple IRAs, defined benefit plans, profit sharing plans, and many, many more. They all have different rules. It’s nuts, but that’s how it is.
Unlike the company plans that require an actual company, individual plans don’t! Almost anyone can set these up on their own.
- IRA. This is called an individual retirement account. You get to con- tribute money and it grows tax-deferred. You might even get a tax deduction. The main difference is you can’t contribute as much into an IRA as you can with a 401(k).
- Roth IRA. Okay, this one is a bit different from the others. Remember how I said you might be able to reduce your taxes with a 401(k) or IRA? Well, with a Roth IRA, forget about that. You can’t save any taxes now, no matter how much you contribute. And at this point, you may be thinking, “Why would anyone want to put money in a Roth IRA?” Even though you don’t get any kind of tax deduction when you put the money in, it grows tax free; and unlike the others, when you take money out of the Roth IRA, you don’t have to pay tax! Do you see the difference? With most retirement accounts, you get a tax break when you put the money in, but then you have to pay tax when you take the money out. With a Roth, you pay the tax when you put it in but not when you take it out. Why does that matter? Well, it may make more sense for you to pay the tax now, or it may be better to pay the tax later. It depends on a lot of different options, but just know there are different accounts, depending on which strategy is better for you.
- Annuities. I could do an entire video or course about annuities. There are so many different kinds and options that it would make your head spin, but let’s touch on a couple of main ideas with annuities. An annuity is an investment where you contribute money and hope for a return. An annuity is different from other investments in that some annuities provide certain guarantees. For example, the annuity com- pany, an insurance company, will guarantee a certain minimum rate of return. They might say, “You give us money and we’ll give you a 5% return each year,” kind of like a CD investment. They might also guarantee a certain amount of income for as long as you live, kind of like Social Security, so no matter how long you live you keep getting a check in the mail. Again, there are lots of different flavors of annuities, but the guarantees are what set annuities apart from most other investments.
That’s your lesson on retirement accounts.
Don’t worry about all of the details. At this point, the lesson is simply that there are special accounts designed to help people save for retirement. The two main types are:
(1) those provided by a company
(2) those that an individual can do
The most common company-provided retirement account is the 401(k) or 403(b), although there are dozens of others, each with their own rules. The most common individual retirement plans are regular IRAs, Roth IRAs, and annuities.
Most people don’t just choose one, but instead, and most often, investors will have several different types. Again, don’t get caught up in the rules for all of them; it’s not important at this point. All you need to know to be money smart is that these special accounts exist and they can help you save for your retirement.
The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.