From 401ks to Roth IRAs: Demystifying Retirement Accounts

A 401(k) is like a retirement starter pack, especially if your employer offers a match (which is free money!). Contributions are taken out of your paycheck before taxes, which lowers your taxable income now, however you’ll pay taxes when you withdraw in retirement. It’s a great choice because it’s automatic – set it, forget it, and watch savings grow. Be aware that if you withdraw early, you'll face income taxes as well as a 10% penalty. This is your meant to be long-term, can't-touch-it money. 

Example: If you’re earning $50,000 a year and contribute 10% to your 401(k) with a 3% employer match, that’s $6,500 saved annually. Over 30 years, assuming a 6% return, that could grow to over $500,000.

Unlike the 401(k), you contribute to a Roth IRA with after-tax dollars, so you won’t get an immediate tax break. The upside? When you take money out in retirement, it’s tax-free. Roth IRAs offer flexibility; you can withdraw your contributions (not your earnings) at any time without penalties. This makes them a good option if you need some of that cash before retirement.

Example: You’re 40 years old and decide to start contributing the maximum amount to a Roth IRA (which in 2024 is $7,000 per year if you're under 50). If you contribute $7,000 annually for the next 25 years until you retire at age 65, and your investments grow at an average annual rate of 6%, you could end up with around $464,000.

The Traditional IRA is a solid option, especially if you’re looking for a tax break now. Like the 401(k), contributions to a Traditional IRA may be tax-deductible, which can lower your taxable income in the year you contribute. However, withdrawals in retirement are taxed as ordinary income.

Example: You contribute $6,500 annually to a Traditional IRA starting at 35, and you qualify for the tax deduction each year. By 65, with a 7% average annual return, your account could grow to about $650,000. Unlike the Roth IRA, these withdrawals will be taxed, so it's important to plan for that.

If you’re self-employed or run a small business, a Simplified Employee Pension (SEP) IRA might be your go-to. SEP IRAs allow you to contribute up to 25% of your net earnings from self-employment, or $66,000 in 2024, whichever is less. This high contribution limit can make SEP IRAs a powerful tool for ramping up your savings if your income changes year to year.

Example: If your self-employment income allows you to contribute $15,000 annually to a SEP IRA from age 40 to 60, with a 6% return, you could accumulate around $555,000 by retirement at 65. Like a Traditional IRA, contributions are tax-deductible, providing valuable tax savings now, withdrawals in retirement will be taxed.

How do you choose? If you’re eligible for a 401(k) with a match, start there. That’s an instant return on your investment you don’t want to miss out on. The best retirement account for you is the one you start funding now. It's okay if you don't have all the answers or much to contribute right away. Starting small and being consistent will get you far.