Meet Bob. Bob is a newly employed college graduate with the urge to invest. Bob just finished our two videos “Why Invest” and “How to Invest,” so he understands how he can easily and effectively invest his money through a robo-advisor. While Bob is proud of this newfound knowledge, one obstacle remains in his path: alphabet soup. Everyday, Bob is confronted by a terrifying array of terms: 401(k), IRA, the list goes on and on. Luckily for Bob, we have him covered. Let’s start with most basic: 401(k)s and 403(b)s. These are tax-advantaged investment accounts, designed for retirement, and offered by either a for-profit employer, in the case of a 401(k), or a nonprofit or government employer, in the case of 403(b). In either case, both accounts are virtually identical, and come in two forms, Traditional and Roth. So what’s the difference? Well, with a Traditional 401(k), the money you put in is pre-tax, and then only taxed when withdrawn at retirement, while with a Roth 401(k) it’s the opposite. So which one should you choose? Well, as the math turns out, Roth 401(k)s are perfect for most people, especially for those in a low to moderate tax bracket, like 25% or below.
In contrast, traditional 401(k)s are generally better for those in a higher bracket. In either case, your employer may match your contributions up to a certain amount, like 5% of your total salary. Sounds pretty great right? After all, free money and tax-advantaged growth, what’s not to love? Well, a few things. One: As of 2016, your contributions are limited to up $18,000 per year. Two: Not only will your employer restrict you to a specified list of funds, you’ll also have to pick them yourself, which can be a real challenge. However, you can avoid this, either by using our recommended robo-advisor to manage your 401(k), or by manually selecting what’s called a life-cycle or target-date fund, which operates much like the robo-advisors we described in our previous video, just with less flexibility and personalization. Three (and here’s the real kicker): you generally can’t cash out of your current 401(k) unless you meet a hardship exemption, like excessive medical expenses.
Plus, even if you do meet them, you’ll still generally have to pay a 10% penalty, plus taxes, on money withdrawn before age 59 and a half. So that’s 401(k)s. Let’s move onto the next account, IRAs. IRAs come in the same two forms as 401(k)s, Traditional and Roth, and for the most part, they have the same tax advantages, withdrawal rules and selection criteria: Roth favors those in low to moderate tax brackets, like 25% or below, while Traditional favors those in higher ones.
However, there’s a few differences between IRAs and 401(k)s to be aware of. One: Your contributions to an IRA are more limited, currently only $5,500 per year across both Traditional and Roth accounts. Two: You’re barred from contributing to a Roth IRA at certain high income thresholds. Three: If you’re a small-business owner or freelancer, you can also open a SEP IRA, which operates like a traditional IRA, just with a much higher contribution limit. Four: Unlike a 401(k), almost every brokerage firm, including robo-advisors, will allow you to open an IRA and select whatever fund you want.
This is incredibly useful, especially if your 401(k) has costly or undesirable options. Plus, withdrawing money is also easier in an IRA, as you don’t need a hardship exemption, though, if you’re below age 59 and half, you’ll still have to pay the 10% fee and taxes. So that’s IRAs. So how do you choose between them and a 401(k)? Well, we have simple rule of thumb. First contribute to your 401(k) until you’ve hit maximum matching, then max out your IRA, and then finally, return to max out your 401(k).
Of course, for most people this is unrealistic, especially considering we only recommend you invest 10-15% of your paycheck for retirement. However, for educational purposes, let’s say you’ve maxed out both. What do you do then? Well, you can then put the remainder of your investing money into a taxable investment account offered by any brokerage firm, including robo-advisors. While these accounts lack tax advantages, they also have zero limitations on contribution size and withdrawals, making them a great home for the rest of your money. Finally, a bit of house-keeping. Whenever you change jobs, you start a new 401(k) with your new employer and leave the old one behind. Whatever you do, don’t cash out of the old one.
Instead, roll it over into a matching Traditional or Roth IRA. This will allow you to consolidate your funds and lower your fees, while avoiding any tax or withdraw penalties. And don’t worry, robo-advisors make this process a breeze. Congratulations! You have finished the investment basics curriculum! If you want to see great robo-advisors or stockbrokers, or just more educational content, be sure to check out our website. .
In this video, you’ll learn everything you need to know about retirement accounts such as 401(k)s, 403(b)s, and IRAs! We cover the difference between Roth and Traditional retirement accounts, when to choose an IRA over a 401(k), what happens to your 401(k) when you leave your company, and much more!
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