Retirement accounts are tax-advantaged ways to save for our future. Most employers offer a 401k or 403b retirement plan, which is based on the type of employer. 401(k) plans are offered by private, for-profit companies, where nonprofit organizations offer 403(b) plans, such as schools and hospitals. Also, IRA’s are a tax-advantaged way to save for our future outside of work, otherwise known as an individual retirement account. In this article, I will review and compare the advantages of each.
In This Article
401(k) and 403(b)
401(k)s or 403(b) plans are very similar to each other and are called tax-deferred accounts, which means your contributions are made prior to receiving your paycheck, lowering your taxable income. As an example: an RN making $70,000 would expect to pay approximately $20,000 in taxes throughout the year. However, if you contributed $10,000 to your 403(b), your taxable income would go down to $60,000. The result? Only $16,000 would be paid in taxes. That is $4,000 less taken from you, and you are making progress towards retirement.
This type of account allows you to defer taxes until retirement because, in addition to tax-free contributions, the account’s growth is tax-free too. However, when you begin making withdrawals in retirement, the withdrawals will be taxed as income. That makes sense because you enjoyed tax-free growth over decades, and your withdrawals will be your retirement income.
In 2020/2021, the maximum contribution an employee can make to their 401(k) or 403(b) is $19,500, and additional “catch-up” contributions are available if you are 50 years or older. Many employers will also offer a match, otherwise known as FREE money.
IRA’s (Individual Retirement Accounts)
The two most common types of IRA’s are Traditional and Roth. They both grow tax-free, but the difference is when and how you get to enjoy the tax benefit of them. For some people, a 401(k) or 403(b) may not be enough to fuel your retirement needs based on your income or lifestyle, which is where the IRA can help. If a Nurse Anesthetist making $175,000 maxed out their 403(b) employee contributions at $19,500 every year, it likely won’t be enough to reach their retirement goals since that equates to a Savings Rate of only 11%.
In a Traditional IRA, your contributions are deductible on your taxes, so that is why it is called a tax-deferred account. The deduction will lower your taxable income for that year, so the benefit is that you save based on your current day income tax with the hopes that your future tax rate will be lower. It is difficult to know what your tax rate will be in the future, and since the Traditional IRA is less flexible than the Roth, the Roth IRA is superior.
Contributions to your Roth IRA are with post-tax income from your bank account. You cannot deduct the contribution like with the Traditional, but the benefits will make up for that. The biggest advantages of the Roth over the Traditional are:
- Withdrawals during retirement are tax-free.
- There are no Required Minimum Distributions (RMD’s), so you are not forced to begin withdrawals at the age of 72.
- You can withdraw your contributions in the case of an emergency before retirement without penalty. (not the growth, though).
These advantages of the Roth make it much more valuable to the vast majority of people compared to a Traditional IRA.
In 2020/2021, the maximum total yearly contribution amount for IRA’s is $6,000 prior to age 50 and $7,000 age 50 and up. This limit is total IRA contributions; you cannot contribute $6,000 to each. The IRS has limits on who gets to directly enjoy the tax benefits of IRAs or at least makes it more difficult for some. Your Adjusted Gross Income (AGI) is used to determine these limits, and your AGI is simply your Gross (total) income minus any deductions.
AGI example: if you are a dual-income household with a gross income of $272,100 and take the standard deduction of $25,100 as well as maxing out two retirement accounts at $19,500 each, your AGI would be $208,000. That is because $272,100 – $25,100 – ($19,500 + $19,500) = $208,000. If you filed your taxes jointly that would make you ineligible to directly contribute to the Roth because of income limits. If you are above the income limit to directly contribute to a Roth IRA, you would need to perform a Backdoor Roth IRA, which is a legal loophole that adds a couple of steps.
Below is a quick view of the key features of a 401(k) / 403(b), Traditional IRA and Roth IRA:
*Roth income restrictions: To directly contribute to a Roth IRA, there are income restrictions. However, you can still contribute to a Backdoor Roth IRA, a legal loophole for those who make above the restriction. More on that soon.
*Traditional income restrictions: There are income restrictions to deduct Traditional IRA contributions. If you couldn’t deduct contributions to a Traditional IRA, you would never directly contribute to it.
Pensions have become exceedingly rare, and social security is hard to count on in the future. Investing in your financial security with a 401(k)/403(b) or IRAs will help prepare you for retirement. Whether you are just beginning to save or nearing retirement, it is not too late to begin improving your financial situation. If you are unsure where to start, check out the Savings Rate article.