Tuesday, September 28, 2010

Tier 4: Retirement Accounts

There are several advantages and disadvantages of a tax-advantaged accounts. The biggest advantage is that they can grow tax deferred, meaning that taxes don't have to be paid on growth until the money is withdrawn. The biggest disadvantage is that they are illiquid, meaning that once you put the money into them it better stay. Early withdrawals can mean extra tax and penalties. The biggest problem with them is that most people contribute to them before they are ready. Then, without savings and protection, unexpected events happen, and suddenly they are in debt and have to make early withdrawals from their tax-advantaged accounts and they incur those taxes and fees.

After, and only after you have the proper protection and savings, and you are out of debt, should you start contributing to retirement accounts. If you are not sure whether or not you have the proper savings or protection see Tier 1 and Tier 2. So many people contribute to their 401k, IRA or 403b plans as soon as they become available. When I got my first full-time job with benefits, I made the mistake of contributing to the 401k plan they offered. I thought it was a great deal because they matched part of what I contributed. The problem was vesting. Vesting is when you gradually earn the right to keep what your employer has contributed on your behalf. If you don't work for them long enough, and I did not, then you don't keep their contributions.

So when I left I didn't get to keep anything that they contributed. I thought, "That's ok, because I was saving for retirement. I converted my small 401k to a Roth IRA and two years later I had lost enough money and my account was so small that the investment company closed my account and sent me a check. So A couple hundred  dollars and a few years got me nothing. That is why it is so important for  you to know when and how to contribute.

Roth VS Normal

In a Roth account contributions are made with money that has already been taxed. The contributions are then allowed to grow tax free and if properly withdrawn the proceeds are tax free as well.

In a normal tax advantaged account you are allowed to make contributions with money before taxes are paid. These contributions are commonly used to defer a tax burden.

As an example a person contributing to a normal account contributes a full $1. The person contributing to a Roth account has to pay their taxes and only contributes $0.70.  If they both grow at 5% for ten years then the Normal account will have $1.63 and the Roth account will have $1.14. Upon withdrawal the Normal account has to pay a 30% ($0.49) tax burden leaving $1.14. Mathematically it doesn't matter if you pay the taxes before or after. The trick is knowing when you will pay a lower percentage of taxes. Will taxes go up or down? Will your tax bracket go up or down?

IRA VS 401k

An IRA (Individual Retirement Account) is essentially for people who do not have 401k's available to them. However, just because someone has access to a 401k does not mean they cannot contribute to an IRA. An IRA is self managed. You decide what you invest in and, you are responsible for the success of your account. However, there are income and contribution limits.

A 401k is a retirement account sponsored by an employer. There are similar types of limits on these accounts, but different amounts. Each account has different rules depending on the plan provider. Generally there are 1/2 a dozen investment options you can choose from based on your time frame. Though I cannot speak on any specific option, usually these aren't too bad (i.e. you could do worse).


Post a Comment