Do you love paying taxes? Ok, stupid joke. But today I want to talk about a couple of great ways to pay a little less and help your future self out in the process. For those who ignore the almost nonstop reminders in the media, the United States has a massive retirement crisis in its not so distant future. It seems that in spite of this being the richest country in the history of mankind, nearly half of everyone living here HAS NOT SAVED A SINGLE FUCKING PENNY for retirement. Many of the people who have saved at least something are still woefully short of where they need to be. With obviously unsustainable pensions (otherwise known as defined benefit plans) mostly relegated to the history books, the
criminals fine, upstanding people in charge realized they would have riots in the streets if they didn’t toss a little bread out to those pesky subjects citizens. And thus, some new tax advantaged retirement savings options were born. So far, they don’t seem to be helping much, but that’s why I and countless others are writing posts like this one. 401ks and Roth IRAs are the two most common tax advantaged retirement savings options and an overview of the basics of both is below.
Both of these offer tax breaks, but only to people wise enough to take advantage of them. In my opinion, they should both be maxed out if possible prior to investing in anything else excluding building an emergency fund – which is actually saving, not investing. And yes, there are other types of these but they are less common and I’m writing for a mass audience. And yes, there are various tricks and loopholes that entire posts could be written on but this particular post is just meant to be a general primer. Also, I am not a tax professional and I don’t know the details of your situation so nothing in this post constitutes specific tax advice. This is for information only. Here are the basics.
- Usually offered by an employer
- Maximum contribution for 2019 is $19,000 + $6000 “catch up” for people 50 and older
- Employers often match up to a certain percentage of your income if you contribute at a required level
- No phase outs but HCEs (highly compensated employees) may potentially have their contributions limited
- Contributions lower taxable income in the current tax year
- Distributions are taxed when taken
- Cannot take distributions prior to age 59.5 without being taxed and charged a 10% penalty
- Usually not offered by an employer
- Maximum contribution for 2019 is $6000 + $1000 “catch up” for people 50 and older
- Phase outs starting at $122k MAGI (modified adjusted gross income) and completed by $137k for single filers, or $193k and 203k for married filing jointly
- Contributions are made using post tax dollars
- Distributions are not taxed
- Contributions can be withdrawn prior to 59.5 but earnings withdrawn prior to 59.5 will be taxed and penalized except in specific “qualifying” circumstances
I think the easiest general concept to remember about the difference between the two is this: 401ks are taxed on the back end, Roth IRAs are taxed on the front. To get the maximum benefit, you need to contribute $25k in 2019, assuming you are 49 or younger and not prevented from it by having a very high income.
If you can’t max out both, I would do the following in most cases. First, contribute whatever your employer requires to get the full match that is offered. For example, if your employer matches 3% of your salary if you contribute 6%, a fairly common setup, you would want to contribute 6% to avoid “leaving money on the table.” From there, I would work towards maxing out the Roth IRA unless you are phased out, in a high tax bracket, or have some reason to expect your income is going to go down significantly in the future. If you can do that, I would put any additional available money towards increasing your 401k contribution percentage. Anything you can do is better than nothing and slow progress is better than none. For example, you could start out contributing whatever you are comfortable with and set up an automatic increase of 1% a year on one or the other or both. If you get even a basic cost of living adjustment at the end of the year, you won’t feel any pain because you will still be getting a raise after taxes. This would particularly be the case if you’re talking about a 401k since you would be lowering your taxable income by increasing the contribution meaning the 1% increase wouldn’t cost you the full 1%.
Hopefully this will help some folks get a better idea of how to handle these accounts. If anyone would like me to get into more detailed subtopics on this, please let me know in the comments or send me an email at email@example.com. Have a great day!