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What is a retirement account? A surefire way to get ahead with investing

  • April 14, 2021
  • Noah Weidner

There’s a myth that investing is for people who have lots of money. This is false. Any money you have left over (after paying your rent, insurance, and other living essentials) could go a long way. 

The problem is that many people are investing using limiting broker apps, like Robinhood and Public, which only provide individual taxable account options (meaning, investing in stocks). This isn’t bad if complemented with other types of investments, but it might mean that you’re leaving money on the table—and every dollar counts.

This is where retirement accounts come in. They give you an opportunity to get ahead with investing. Instead of throwing your paychecks into Robinhood or Public, it’s time to take care of your long-term financial stability with tax-advantaged retirement accounts. There are quite a few benefits that retirement accounts provide:

Benefits of retirement accounts

Avoid capital gains taxes: The majority of income-earning Americans using individual taxable accounts on brokerage apps, such as Robinhood, will have a bill to pay when the tax man sees your gains for the year. Unless you’re planning on losing money, you might want to turn to a retirement account to invest for the long-term.

Reduce your end-of-year tax bill: Contributing to a 401(k) or an IRA will allow you to invest in yourself and reduce your tax bill in the process. This is why it’s imperative to put as much money into retirement accounts as possible. However, there are some exceptions to this rule. 

Achieve your financial goals faster: Retirement accounts generally come with penalties on withdrawals. This is meant to deter people from withdrawing from these accounts, since they are meant to be long-term investment vehicles. However, there are some exceptions: you can tap into a Traditional or Roth IRA if you’re a first-time home buyer, paying for college expenses, and a few other situations.

By minimizing your capital gains, maximizing deductions on your taxes, and investing with the long-term in mind, you’ll be able to maximize every dollar you invest. Let’s take a look at the most common kinds of accounts you can use:

Types of retirement accounts

Most people are going to have one of two accounts: a Traditional or Roth IRA and/or a 401(k). There are some outliers. Government employees, self-employed individuals, teachers, and other professions have their own plans. We’ll talk a little bit about those near the end. But, for most of you, the top two accounts are what will count for the most points:

Traditional IRA vs. Roth IRA — $6,000/year

If you made any amount of money this year, you can start stowing away up to $6,000 of your income in either a Traditional IRA or Roth IRA. Here’s a general overview of these two kinds of retirement accounts:

Traditional IRA: It’s an account that allows tax-free contributions now. This also allows you to reduce your taxable income (AGI) at the end of the year, since contributions can be deducted. You will be taxed on your withdrawals (which will generally be when you’re 60 or older, retired, making less money.)

Roth IRA: It’s basically the opposite of a traditional IRA. Contributions are not tax-deductible and you’ll pay taxes on contributions now, rather than later. This might be attractive to people who believe that taxes will go up in the future. Instead of getting a deduction (reducing your taxable income now), you’ll get tax-free withdrawals after you’ve turned 59 ½ or for other qualifying reasons such as a first-time home purchase, college expenses, or birth/adoption expenses

For these accounts, you’ll generally need to set up an account yourself. You can consult a financial planner or advisor, use a robo-advisor, or self-manage your account if you want. There’s some other factors to consider, which you can check out on the IRS’s website

However, you might still be wondering: which account is best for me? It depends! You have to consider how much money you’re making now vs. what you plan to make in retirement, what you are contributing to other retirement plans such as 401(k)s or SEPs, and what aligns with your own views. Here are a few more things to consider before choosing.

401(k) — Up to $19,500/year

If your employer doesn’t suck, you should qualify for a 401(k). A 401(k) is a retirement plan offered by employers that gives employees a tax break on the money they contribute. Your employer will withdraw these contributions from your paychecks and invest them into funds. Your employer will generally provide you access to a portal to manage your 401(k) and the funds you’re investing in.

For tax year 2021, the maximum contribution limit for employees participating in a 401(k) plan is $19,500. This means that you can contribute up to $19,500 to your 401(k) for the year, if you’d like. Every dollar of that contribution will be pre-tax, which will help you reduce your end-of-year tax bill. For most Americans, $19,500 is a sizable amount of money–so, don’t feel bad if you don’t max it. 

One final thing to keep in mind is whether or not your employer offers a 401(k) employer match. If your employer is providing a match on your contributions, it might be smart to start by contributing to your 401(k) first before investing with other accounts.

Other Plans — Varies

Besides Traditional IRAs, Roth IRAs, and 401(k)s, there are plenty of other retirement plans or options. Nobody will qualify for all of them, but some might find others useful as primary or secondary retirement accounts. 

For self-employed people there are SIMPLE IRAs, SEPs, and SARSEP plans. For government employees, there are 457 plans. For teachers/educators, there are 403(b) plans. There’s even a Roth-flavored 401(k) called a Roth 401(k) that you can request from your employer.

These retirement accounts might benefit you more depending on your job, income, and other factors. They also, as a result, have different rules. That said, you should get acquainted with these plans separate from the ones above. Consult a tax professional for more information.

How to open a retirement account

After evaluating your options, consulting a tax professional, and fielding benefits from your employer, you might be wondering what the next steps look like. For some of you, the weight will be carried by your employer: they will instruct you on how to access your 401(k), 457, 403(b), or other accounts. However, if you want to start a Roth IRA, a Traditional IRA, or you’re self-employed, a few extra steps will be required.

When it comes to managing your own individual accounts, like a Roth or Traditional IRA, you’ll have to choose a broker that offers it. For people who like to be hands-off, one way to do that is to go with a robo-advisor or hire a certified financial advisor from a company like Vanguard. If you are an ardent trader and love the market, you might already be confident to start your own account and jump in.

It’s important to look at retirement accounts as investment mediums to “go long” with. You should generally invest in a mix of index funds with a track record of success, high-conviction stock picks, and a collection of other assets that might help supplement your portfolio. Once you’ve maxed your retirement accounts, feel free to retreat to your Robinhood app to YOLO your money on meme stocks–or, stocks you believe in.

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