Updated: Nov 29, 2020
What a boring topic, right? I used to think so. Until I realized the importance, significance and what you could do with them. You have probably heard some of these words/abbreviations-401K, IRA, Roth 401K, Roth IRA, Brokerage, HSA. Are they all just jumbled up letters? What do they mean? I’m not a Financial Planner, nor expert on these topics, but it’s my goal to touch on these accounts on a level that the average individual will understand.
First, I’ll provide some definitions of the aforementioned account abbreviations. To put it simply, a 401K plan is a retirement account sponsored by an employer. There are several different types of 401K accounts, from Solo 401Ks, to 403Bs (offered by public schools), Safe Harbor 401Ks, Self-Directed 401Ks, and Roth 401Ks (I’ll touch on below), etc. For this example, we’ll discuss the typical “traditional” 401K account sponsored by a W2 employer.
Next, is an IRA. This stands for “Individual Retirement Account”. These accounts are not employer sponsored. So, for example, you could literally go on Vanguard, Fidelity, etc. right now and set-up this account and start contributing.
Third, is a “Roth”. There is the employer sponsored Roth, known as a Roth 401K and a Roth IRA, which is not employee sponsored. Fourth, is an HSA account. This stands for Health Savings Account. I bet you’re wondering what this is doing on this list of retirement accounts. We’ll discuss below. Lastly, are Brokerage Accounts. These types of accounts are utilized typically for medium/long-term savings in stocks and ETF (Exchange-Traded Funds). Although, some experts might utilize this type of account for short term trading, like “day-trading” for example. Brokerage Accounts do no have the tax benefits as the traditional retirement accounts as mentioned above.
Now, that I’ve provided a definition of each of the types of retirement accounts, I’d like to dive deeper into their individual meanings. Some of my first blog posts touched on budgeting. I would consider that one of the first steps you can take towards frugality. Making a game plan for your retirement accounts allows you to take that next step and utilize the additional savings you have from living a frugal life to fuel and save for your retirement.
The majority of my readers have a job with an employer that provides an employer sponsored retirement account, known as a 401K. A traditional 401K plan allows you to contribute money each pay period into a retirement account, tax-free. You will not be taxed on this money until you withdraw funds in retirement at age 59 and 1/2 years old . When you take distributions from these accounts down the road, they are known as RMD (Required Minimum Distributions). I am not going to touch on RMD’s because the age in which you start taking distributions varies depending on what kind of account that you are enrolled in. There are even ways to begin taking RMD’s before you reach the required retirement age as well.
There are a few benefits of contributing to a 401K plan. First, you are contributing towards your future and retirement. Second, you are decreasing your taxable earnings, by deferring the tax to a future time frame. You still will have to pay tax on the funds, but ideally, you’ll be taxed when your income is hopefully lower (when you are retired), thus decreasing your tax rate. It’s a strategic game plan in this world of taxes we all live in. Third, many employers offer a company match when you contribute to your 401K plan. For instance, if you contribute 3% into your account, your employer will match you dollar for dollar up to the 3%. These amounts vary by employer. Some employers might not match at all. 3% seems to be fairly standard. Some employers may give 5%. I’ve even heard of some employers match dollar for dollar up to the contribution limit. Which brings me to my next point, contribution limits. The IRS says that for 2019, you can contribute up to $19,000 into your 401K (including contributions to a Roth 401K) for the year. For those aged 50 and older, you can contribute “catch-up contributions” in the amount of $6,000, for a total of $25,000 per year. This $19,000 is then tax deductible and will save you money come tax season.
Next, we discuss “IRAs”, specifically Traditional IRAs (different from a Roth IRA, which i’ll touch on below). “Traditional” Individual Retirement Accounts are different than 401Ks in that they are not employer sponsored. If you don’t have an employer that offers a 401K, or even if you do, you can set-up an IRA. The contribution limit for an IRA is $6,000 for the 2019 tax year. For those 50 years or older, you are able to contribute an additional $1,000, for a total contribution amount of $7,000. For those interested in contributing to both a 401K & Traditional IRA, keep in mind that although you are able to contribute to both, there are limits based on income as to how much can be considered “tax deductible” and this is based on your AGI (Adjusted Gross Income).
Now, we turn to the Roth 401K. This is also an employer sponsored retirement plan. The difference between a Roth 401K and a Traditional 401K plan is that the Roth account is taxed right now. The benefit of this account is that since it’s taxed now, you can then invest the funds and when you are ready to use them in retirement, you are not hit with anymore taxes. Generally, the younger you are the more it is recommended that you start with a Roth 401K, because when you start your career you are typically in a lower tax bracket and the money in your account is the exact amount you can withdraw in retirement without having to worry about taxes later on. The maximum contribution limit for this account is $19,000 for the tax year 2019. If you are contributing to an employer sponsored plan and are teetering on the maximum contribution limit of $19,000, keep in mind that the amount is an aggregate between your Traditional and Roth 401K accounts. For example, you can contribute $9,500 in each account, or whatever scenario works best for you, up to the $19,000 total amount.
Aside from the Roth 401K option, is a Roth IRA. This option, like the Traditional IRA, is non-employer sponsored. If you don’t have an employer sponsored option, or if you are maxing out your 401K, you might consider contributing to a Roth IRA. As with a Traditional IRA, the limits for Roth contributions are $6,000 for the 2019 tax year, with individuals 50 and older given the ability to contribute an additional $1,000 in “catch-up” contributions. There are also income limits for whether or not you are able to contribute to a Roth IRA. However, there is a fairly simple work around, called a “Back-door Roth”. Basically, you contribute to a Traditional IRA and then convert to a Roth after the fact. This is completely legal. In fact the IRS has gone as far to even explain that you are able to do it. Consult with the IRS website for income levels before contributing to a Roth IRA and understand how to make the conversion with your account holder. Most account holders (like Vanguard) are very well versed in how to make a conversion from a Traditional IRA to a Roth IRA, so it should be a fairly straight forward and simple process.
Next up in the retirement and savings account portfolio is the “Brokerage Account”. This type of account is typically established to invest in stocks, ETFs, etc. Although, the previously discussed accounts are also invested in stocks, there are limitations as to the options available. For a brokerage account, the options are endless. You can invest in Index Funds (Small Cap, Large Cap, etc.), specific companies like Apple, Amazon, etc. One of the most important things to keep in mind when investing in a Brokerage account are Capital Gains taxes. This is extremely important. Funds kept in a brokerage account for shorter than a year period are considered Short Term Capital Gains. I have provided two tables below to show the differences in cashing out on an investment under a year old, versus a year or older. For example, let’s say you purchased a stock for $1,000 and it grew to $2,000 in value. However, you sold it before it was in the account for one year, you’re looking at a short term capital gain hit. The amount of tax depends on your income and whether you file Single, Married Filing Jointly, or Head of Household. In this example, if you are in the 37% tax bracket, you can expect a tax of 37% on the $1,000 profit you made. However, if you hold that same investment for over a year and make $1,000 of profit, your taxable rate would be 20%; assuming the same tax bracket. Now, let’s also consider that you wait to sell the investment in a later time-frame when your yearly income has significantly decreased. You could hypothetically pay 0% in Capital Gains down the road if you are strategic about when you sell.
Now, we turn our attention to the HSA or Health Savings Account. This is probably the least known retirement account. When most people hear HSA, they think of an account to save funds for a health care expenses. That is correct, it can absolutely, 100% be used for that. For me, however, I use mine to save for retirement. Depending on your health plan, will depend on whether or not you are even able to utilize an HSA. Typically, “High Deductible” health plans allow for an HSA to be tied to them. The idea and premise is to somewhat hedge your bets. Since your deductible is higher, your premium is typically lower than an HMO or PPO plan, for example. An HSA allows you to save money each pay period, so that if funds are needed for co-pays, deductibles, etc., the funds can be pulled from the HSA to go towards necessary health care expenses.
Okay, now I bet you’re wondering “what does this have to do with retirement”? Now, for the fun part. First, I have to premise and say that you need to check with your employer to first understand the rules pertaining to your HSA account and how and when it can be invested. But, many HSA accounts can be used as an investment vehicle once a certain amount of money is established in the account. For example, my employer allows me to invest in my HSA similar to a 401K account once there is $1,000 in the account. This money is also tax deductible similar to a 401K account.
Another question you might have is, “why would I want to invest my HSA”? The reason is that an HSA is the only retirement account that provides a “double tax benefit”. What this means is that your contributions lower your taxable rate and you can withdraw funds for health expenses without a tax penalty. Additionally, after age 65, you can withdraw the funds for any reason (although taxable at that time). Lastly, there are no time restrictions as to when you are required to withdraw funds for a medical event. For example, let’s say you have a surgery and your out-of-pocket deductible is $2,000. Obviously, you could pull the funds out directly from your HSA to cover this. However, if you are utilizing the HSA in a strategic manner for retirement, you might have the ability to just pull the $2,000 from your bank account and defer the withdraw until a later date. Now, why would you want to do that? Well, if you are investing the funds and you pull from the account, it’s going to take longer for this nest egg to build. However, let’s say down the road, when you are ready to pull from the account, you make the withdraw at that time, it’s tax free. Additionally, this allows the funds to compound quicker by not making the withdraw at that earlier time. Contribution limits for an HSA for the tax year 2019 are $3,500. This includes any contributions from your employer. For example, if your employer contributes a $750 match to your HSA, you can only contribute $2,750, to reach that $3,500 total.
Besides contributing to retirement accounts, funds can always be kept in a Money Market (high interest savings account). Although the percentage earned on this type of an account is likely less, the risk is as well. It is wise to diversify investments and to have cash on hand for emergencies. Stock piling some cash in a savings account such as a MM is a strategic and wise move as part of your investment portfolio.
I hope this overview on retirement accounts has been beneficial. I know all of the abbreviations and account types can be both frightening and cumbersome. However, once understood, the knowledge provides you power to take control of your retirement and future. Creating a plan that is right for you and your family is key in attacking your retirement. Whether this involves the usage of 401K plans, IRA, both, an HSA, brokerage, etc., you can weigh the pros and cons of each, seeing the tax implications based on your income, the specifics of each type of account, etc. and how it effects you; providing the best way to grow your retirement nest egg. Cheers to saving, retirement and of course, frugality!