Retirement Accounts and Strategies for Young Investors
Updated: Dec 29, 2020
401(k)'s, Roth, SIMPLE, SEP...
For many young professionals, saving for retirement through an employer sponsored 401(k) or IRA is commonplace. There are, however, variations of these accounts, other types of accounts, and a few strategies related to these accounts that should be considered. Below is an outline of the various types of retirement accounts:
Types of Accounts 401(k): Retirement plan sponsored by larger businesses with more employees. Monthly pre-tax deductions from your paycheck are taken and invested in mutual funds offered by the selected 401(k) plan. Future withdrawals are taxed at an individual's ordinary income tax rate at the time of withdrawal and required withdrawals are mandated after age 70 and a half. Maximum contributions for the year are currently $19,000. SIMPLE IRA: Retirement plan sponsored by smaller businesses with less employees as they offer lower overhead expenses. These are managed by an investment advisor (such as 1620) and the maximum pre-tax contributions are $13,000. There is typically a company match component of 3% of the employee's salary. Future withdrawals are handled in the same way as 401(k)'s. SEP IRA: This is an IRA for those who are self-employed. Contributions are made by the owner of the business and the contribution made as a % of the owner's salary must also be matched for any employees. Employees cannot make additional contributions to the SEP but can contribute to a traditional IRA. With these plans, the business owner can easily adjust contributions to the plan in order to align with the ebbs and flows of the business. The current contribution limit for a SEP is 25% of an employee's salary up until a max contribution of $56,000. ROTH IRA/401(k): Contributions are made on a post-tax basis by the individual. Since individuals have already paid taxes on the dollars that they have contributed, no taxes are paid on future withdrawals from the account.
Traditional IRA: This is not an employer sponsored retirement account and can be in either the pretax or post-tax (ROTH) format. Maximum contributions for the year are $6,000. Contributions can be made into this account while also participating in a SEP or SIMPLE IRA. Rollover IRA: Individuals are able to convert a 401(k) from a former employer into either a Traditional or ROTH IRA. A common reason for this is so that it can be managed directly by an investment advisor with a greater amount of investment options.
Pre-Tax or Post-Tax: Which One is Better? The benefit of pre-tax contributions is that taxes are deferred to the future, lowering your current taxable income and lowering your current tax burden. With a $60,000 salary, a 15% tax rate, and no pre-tax contributions, the taxes paid are $9,000. If you contribute 6% of your salary after tax, you are then left with $45,000. In the same scenario, a pretax contribution of 6% of your salary results in $8,460 paid in taxes and $47,940 left over after tax and contribution. As you can see, there is an explicit present day benefit to pre-tax contributions. So, what is the benefit of contributing after tax dollars? Pre-tax contributions must be taxed at some point, right? As stated earlier, future withdrawals from your retirement account are taxed at your ordinary income tax rate at the time of withdrawal. If all goes as planned, the individual's tax rate will be higher in the future than it is now. The benefit of contributing post-tax dollars now, especially as a young professional, is that the tax rate we pay on contributions today is likely to be significantly lower than the tax rate we would pay on withdrawals in the future. Additionally, the gains that you accumulate are not taxed when taking withdrawals from a ROTH account but they are taxed when taking withdrawals from a traditional account. Remember, future withdrawals from a ROTH account are not taxed. In summary, there can be a sizable benefit to contributing post-tax dollars as someone who is early on in their career. In either case, there is an added benefit of growing your investment without paying taxes annually on income and gains that are generated. Ultimately, it may be advantageous to have one of each type of account.
Rolling a Pretax Account into a ROTH IRA After a Significant Market Drop One more quick tip: For those with a traditional 401(k) or IRA, there are opportunities where it can be advantageous to convert the account into a ROTH account. If there is a significant drop in the market leading to a sizable drop in the value of your traditional IRA, it may make sense to convert this account into a Rollover ROTH IRA (this conversion is also possible for a 401(k) under two scenarios: If you are still working at the company that is sponsoring the 401(k), they must also offer a ROTH version. If you have left the company, you are able to convert the 401(k) into a Rollover ROTH IRA). In doing so, the individual pays a one-time tax on the dollar value of the account being transferred and avoids having to pay taxes on the assets ever again. This can be an advantageous strategy for someone who is relatively early on in their career, is in a relatively low tax bracket, and has the financial flexibility to pay the additional taxes on the transferred assets. Main benefit: If your account is at an unrealized loss (contributions to the account have on average lost value), you are essentially paying less taxes on your to-date contributions than you would have if you had contributed post-tax dollars initially while you are also removing the burden of paying taxes on the account in the future. In this scenario, taxes paid on the assets over the life of your account are minimized.
Other Considerations: Make sure to assess how the taxes due impacts your financial status. Will the conversion put you into a higher tax bracket? Are you comfortable with your ability to pay the taxes due on the conversion?