Retirement Accounts: IRA and 401(k)

Tax-advantaged retirement accounts are among the most powerful wealth-building tools available. Understanding IRA and 401(k) options can save you thousands in taxes. [DEFINITION] Tax-Advantaged Account: An investment account with special tax treatment—either tax-deferred growth (pay taxes later) or tax-free growth (pay taxes now, never again on gains). ### Traditional vs Roth: The Core Difference **Traditional (Tax-Deferred):** - Contributions reduce current taxable income - Investments grow tax-free - Withdrawals in retirement taxed as income - Best if: Tax rate is higher now than in retirement **Roth (Tax-Free Growth):** - Contributions are after-tax (no upfront deduction) - Investments grow tax-free - Qualified withdrawals are completely tax-free - Best if: Tax rate is lower now than in retirement [KEY] The decision comes down to: Pay taxes now (Roth) or later (Traditional)? Young investors often benefit from Roth; higher earners often benefit from Traditional. ### 401(k) Basics **Contribution limits (2024):** $23,000 ($30,500 if 50+) **Employer match:** Free money—always contribute enough to get full match **Investment options:** Limited to plans offered by employer [EXAMPLE] Your employer matches 50% of contributions up to 6% of salary. You earn $60,000 and contribute 6% ($3,600). Employer adds $1,800. That's an immediate 50% return on your contribution. [TIP] At minimum, contribute enough to get your full employer 401(k) match. It's the closest thing to free money in investing. ### IRA Basics **Contribution limits (2024):** $7,000 ($8,000 if 50+) **Traditional IRA:** Deductible if you meet income limits **Roth IRA:** Income limits for direct contributions **Investment options:** Almost unlimited—stocks, bonds, ETFs, etc. ### Roth IRA Income Limits (2024) - **Single:** Phase-out $146,000-$161,000 - **Married filing jointly:** Phase-out $230,000-$240,000 - Above limits? Consider "Backdoor Roth" conversion ### Investment Strategy by Account [FORMULA] Tax-Efficient Placement: - **Taxable accounts:** Index funds, municipal bonds (tax-efficient) - **Traditional IRA/401(k):** Bonds, REITs (tax-inefficient) - **Roth IRA:** High-growth stocks (maximize tax-free growth) ### Withdrawal Rules **401(k) and Traditional IRA:** - 10% penalty before age 59½ (with exceptions) - Required Minimum Distributions (RMDs) starting at age 73 - Withdrawals taxed as ordinary income **Roth IRA:** - Contributions can be withdrawn anytime tax/penalty-free - Earnings penalty-free after age 59½ and 5-year rule - No RMDs during owner's lifetime [WARNING] Early withdrawals from retirement accounts can trigger 10% penalties plus taxes. Exceptions exist for first-time home purchase (up to $10,000 from IRA), medical expenses, and certain hardships. ### Rollover Options When leaving an employer: 1. Leave 401(k) with old employer (if allowed) 2. Roll to new employer's 401(k) 3. Roll to Traditional IRA (most flexibility) 4. Roll to Roth IRA (pay taxes, convert to tax-free) [EXERCISE] You're 25, expect higher income later, and can contribute $10,000 annually. Your employer offers a 401(k) with 4% match. How should you prioritize? |ANSWER| 1) Contribute enough to 401(k) for full match (free money). 2) Max out Roth IRA ($7,000)—you're likely in a lower tax bracket now. 3) Return to 401(k) for remaining capacity. This strategy captures the match, prioritizes Roth while taxes are low, and maximizes tax-advantaged space. [SCENARIO] You're 35 with $50,000 in a 401(k) from an old job. You now earn too much for direct Roth IRA contributions. What might you consider? Options: 1) Roll to Traditional IRA for more investment choices. 2) Roll to current employer 401(k) if good plan. 3) Consider partial Roth conversion if you expect higher taxes later—pay taxes now on converted amount, future growth is tax-free. 4) Use "Backdoor Roth" for new contributions if income is too high for direct Roth.