In this article, I discuss the financial future for many Americans. Additionally, explaining the differences between Traditional/Roth IRAs and 401(k)s.
- Information on American retirement accounts by age group.
- Looking at two main types of retirement accounts, Roth IRAs and 401(k)s.
- Briefly cover rollover IRAs, explaining the difference between direct and indirect rollover.
Grim Financial Future For Americans
In a report from the U.S. Federal Reserve, their research found that 25% of Americans have no retirement savings. 13% of Americans above age 60 have no retirement savings account. This is alarming as the current retirement age is 66.5, meaning they are left with 6.5 years to save their remaining income stream.
To put it into perspective, if you were to start a Roth IRA at age 60, you would have $59,100 by the time you retire at age 67. Look into your past spending, compare it to your retirement savings and see how many years you could live off of it.
To reinforce the concerning news, according to Northwestern Mutual’s 2019 Planning & Progress Study, 22% of Americans have less than $5,000 in their retirement savings accounts. It would be difficult to maintain a healthy and long retirement if you are planning to live off of social security.
To combat this data, I encourage every reader to assess their current spending habits and reduce their non-fixed expenses. This way, it will encourage you to utilize that extra money towards a savings account.
As an advocate for long term growth, it is a no brainer to incorporate a retirement account to my personal finance.
Considering our economy is always shifting, I am not interested in being dependent on social security or any government aid when I am retired.
We will focus on Roth IRA and 401(k)s for today, since these are the most well known and often discussed about when handling retirement accounts.
Two Main Types Of Retirement Accounts
Individual Retirement Accounts (IRAs) are divided up into two categories, traditional and Roth. The key difference between the accounts are how they are taxed.
Traditional accounts are taxed once you start withdrawing your money. While Roth accounts are taxed upfront, allowing you to be tax-free when you are withdrawing.
Roth IRA benefits
- Withdrawals are tax-free (Must be age 59.5+ and owned account for 5 years).
- Not counted towards your taxable income.
- Contribute at any age you want.
- You can convert an existing traditional IRA or 401(k) to a Roth IRA.
- No required minimum distribution.
- Withdrawals are taxed if you do not meet requirements.
- Taxed upfront, compared to traditional accounts.
- Income limits ($122,000 or below to contribute maximum amount to Roth IRA).
- Investment cap is $6,000 per year if below age 50, $7,000 if above 50.
While a Roth IRA has a smaller investment cap than a 401(k), you are able to own more than one IRA. Although it would be difficult to manage more than one account, it is possible to have your retirement safeguarded from financial burdens.
Let us model a Roth IRA account both planning on retiring by age 67.
Now, let us model a traditional IRA.
Comparing both of these accounts, we can clearly see that the Roth IRA is significantly better due to its upfront taxes. Once you start withdrawing from your traditional IRA, taxes take a portion of your retirement savings.
Traditional accounts are better if you are in a lower tax bracket by retirement.
The key difference between a Roth IRA and 401(k) is the way to open the account. 401(k)s are offered by your employer and can only be accessed if you are employed.
- Assuming your employer is matching your contributions, it is free money.
- You can choose your investments.
- No income limit to contribute.
- Contribution limit for 2020 is $19,500.
- Only available if employer offers.
- Investment options are usually limited.
- You have to start taking money out when you turn 72.
- You cannot make withdrawals until you turn 59.5 years old.
- You have to pay 401(k) fees and fund fees.
- You cannot invest more money into the account if you leave your job.
Although there are restrictions to withdrawals, in special circumstances such as significant medical expenses or disabilities you are allowed to withdraw without being penalized. Here is an article that expands on hardships.
We will model a Roth 401(k) plan first,
Now, let us model a traditional 401(k).
From a glance, it would look like the traditional 401(k) is better, since you have more money in your retirement account. However, once you begin withdrawing from the account, it will be taxed as ordinary income.
This is where I believe the Roth accounts are better, since you have already paid your taxes upfront when depositing into your IRAs.
It goes without saying, if your employer offers a 401(k) plan, I encourage you to take it. Especially if they are matching your contributions, as that is free money towards your retirement. If you have not considered creating a Roth IRA, then a 401(k) is a great way to kickstart your retirement accounts.
When you are planning on leaving your employer, ensure that you have created a rollover IRA. Despite not many people talking about this, it is important to make one to prevent yourself from being taxed heavily.
This will save you time and headaches since the IRS will withhold 20% of your assets without it. Furthermore, you have to relocate your funds within 60 days, or else you will be taxed twice, an income tax and a penalty tax.
To really understand how Rollover IRAs work, we need to know that there are two types, indirect and direct rollover. The differences between the two are how the money gets transferred.
An indirect rollover’s transfer is providing the funds to the employee via check for deposit to a personal account. From there, the owner must transfer that money into a new IRA within 60 days to avoid taxes.
Realistically, this is the stressful way to handle your retirement account as you are subject to taxes if you fail to meet the deadline.
A direct rollover transfer is where the employer transfers the money directly into your IRA, preventing you from ever having any hands on the funds. This will help you have peace of mind when transferring funds, compared to indirect rollovers.
It is important to note, that direct rollovers are also subject to tax penalties but they are less likely to happen if you have already established an IRA to transfer your funds to.
Which Option To Pick?
Many financial advisers unanimously agree that direct rollover is the correct approach. It saves you time and peace of mind.
In the case that you are needing the money immediately, an indirect rollover would be a better option as you are able to access your funds for whatever you need. The remaining funds must be deposited into a new IRA or else you will be subject to tax and a 10% withdrawal penalty will occur, assuming that you are below age 59.5.
To reiterate, in most cases choosing direct rollover will save you time and energy.
Where To Start Your IRA?
Creating an IRA has never been easier, there are plenty of brokerages out there eager to help you start one.
Here is a list of renowned brokerages available,
If you were on the fence or confused on how to start an IRA, I encourage you to reach out to any trusted brokerage as they are far more knowledgeable than I am.
There is no right or wrong answer to choosing a retirement account. I would personally choose the Roth accounts over traditional due to taxes. However, It is simply starting one to ensure that your retirement is well deserved and stress free.
Comparing the charts between a Roth IRA and 401(k), we can clearly see that the 401(k) is significantly better. This is assuming that your employer has offered you a 401(k) and is matching your contributions. If they are not offering you a 401(k), consider asking them about it.
It is important to note, that you are able to have a Roth IRA and a 401(k), so do not feel discouraged in owning both types of accounts. Both of them offer unique benefits with their own downsides.
Max out your Roth IRA and 401(k) as they have fantastic tax breaks compared to regular investment accounts.
To reiterate, utilize compound interest to the fullest capabilities, ask your employer about retirement plans available, and max out the accounts each year.
As always, I hope you found my article informative.
Questions, concerns, or feedback? Please feel free to fill out the form below as I am always reading your comments to improve my writing. Stay healthy everyone!