Retirement – Part I: What are all these accounts?

Welcome back, my dear reader! This week’s posts will build on a prior post in which I talked about how retirement got so complicated. If you’re curious how we got into this mess, take a look. I promise this will be here when you return.

When we talk about retirement, what most people refer to as complicated is the bewildering mix of accounts that constitute what the average American would call the retirement planning tools. Let’s take a moment to discuss these accounts, because you see, as usual the Handy Millennial is here to help.

Government Incentivized Accounts

Retirement accounts give the holder special privileges. These privileges are granted to us by our magnanimous government to spur us along to do something they (the government) want us to do.

(Yup the verb to spur really does come from old-timey horse spurs.)

But the government does not have too many tools at its disposal to do said spurring. In fact, in the United States, the government only has one lever that it pulls to indicate which way it expects you to behave: Taxes.

So a privileged account is really an account where the government incentivizes you to do something with your money by changing how its taxed. And they are really all the same; the only thing that changes is the answer to one or more of these four questions:

  1. What is the savings goal of this account?
  2. How is this account funded with respect to taxes?
  3. What taxes are levied against the money in the accounts?
  4. When can the money be withdrawn penalty free?

So let’s take these questions one by one and see what the options are.

What is the savings goal of this account?

When it comes to retirement accounts this is easy: save for your retirement. Remember, no one is coming to the rescue.

How is this account funded with respect to taxes?

This is one of the two trickier questions. There are generally two ways to fund a retirement account: With after-tax dollars and with pre-tax dollars. When we say after-tax, we mean your paycheck minus the payroll taxes you see removed from each check. Uncle Sam has taken a healthy bite and he is happy and full.

When we say pre-tax dollars, we mean money taken out of your paycheck before Uncle Sam got his cut, thereby reducing the income available to tax. Uncle Sam isn’t so happy about this. For now, he’s hungry. Let’s remember this for later, because he always gets his fill, now or later.

What taxes are levied against the money in the accounts?

This is another easy one. You see in order to incentivize you to save, the government waives taxes while the money is in the account. Now you might wonder, what taxes?!? Well hopefully your money is growing!!! So there will be interest, dividends, distributions, etc. etc. Normally these would be taxed, but not in a special retirement account.

When can the money be withdrawn penalty free?

This is the important one. Generally, if it’s a retirement account, then you can take it out when you have reached age 59 and 1/2. Huh? Why’s that? Well, just because… And isn’t that how it goes so often.

Now before this magical age, when you can get the money without paying a penalty depends on your answer to question #2. If you funded the account with pre-tax dollars, then Uncle Sam gets hungry. He insists that you pay your fair share of income taxes on this money and then he has a second helping – a 10% penalty.

If you funded your account with after-tax dollars then you can take back what you put in, but not one more cent. Meaning, you can take out your contributions, but not any of the growth – dividends, interest, distributions, etc.

Do you have to withdraw the money?

Again, the answer depends on your answer to #2. Particularly if the answer to that question was pre-tax money, meaning you haven’t paid taxes on it. Remember that I said Uncle Sam is hungry? Well he’s happy to let you do your thing until the magical age of 70 1/2. But then he gets impatient.

You see my dear reader, one day it is fairly likely that you will die. And Uncle Sam does not want you to die before paying your fair share. So at age 70 and 1/2, he insists that you begin withdrawing so that he can collect taxes from you on this money.

If you funded your account with after-tax money, then you are welcome to hold on to it forever.

Exceptions

Now this a biggie. Most people don’t realize this, but these accounts all have exceptions that relax the rules on how you can get your money out. Some people call this a flaw. They call retirement savings in the USA “leaky.” The Handy Millennial disagrees. You see, these exceptions allow people to use their retirement savings as the ultimate emergency fund in case of:

  • Medical Bills
  • Home Foreclosure
  • Death
  • Disability

So while you are saving for a far off goal, you can rest easy knowing that should you get sick, or fall behind on you bills, or become disabled, then you can fall back on this money.

What are these magical accounts called?

Lets conclude with some examples of retirement accounts:

Traditional IRA/401k

This is the one the type of account most people are familiar with. You use pre-tax money to fund the account, and when you withdraw it, it appears as income as far as the government is concerned. Think of this as growing your future income.

How does this fit our questions? Well lets see:

  • What is the savings goal of this account? – Saving for retirement.
  • How is this account funded with respect to taxes? – Funded with pre-tax money.
  • What taxes are levied against the money in the accounts? – None while the money is inside.
  • When can the money be withdrawn penalty free? – Age 59 1/2+ or if something really bad happens to you. You must begin withdrawals at age 70.

Roth IRA or Roth 401k

This is the main alternative to the traditional retirement accounts. You fund these with after-tax money. When you withdraw this money, it’s like a savings account: whatever you withdraw is not taxed. Think of this as a savings/investing account on steroids.

How does this fit our questions? Well let’s see:

  • What is the savings goal of this account? – Saving for retirement.
  • How is this account funded with respect to taxes? – Funded with after-tax money.
  • What taxes are levied against the money in the accounts? – None while the money is inside.
  • When can the money be withdrawn penalty free? – You can take out what you put in tax free anytime. Any appreciation (growth) is taxed at your current income tax rate until age 59 1/2. Then it’s tax free.

The Roth accounts also have one big perk. You can withdraw the money for reasons other than retirement, namely education and buying your first home. This means that while these are nominally retirement accounts, you can use them as tax-free savings accounts.

Conclusion

So there you have it. Retirement accounts in a nutshell. Not really so difficult is it? It’s just a matter of taking the bird’s eye view!

Come back Thursday to learn how and why it’s important to trade off each of these accounts while planning your retirement.

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