A quick primer on retirement accounts

If the suggestion to “save for retirement” has you wondering where this money goes, here’s a primer on the different retirement accounts.

Saving for retirement should be both simple and easy, but unfortunately it isn’t either.

It isn’t easy, because it takes most of a working lifetime to be able to save enough money to be able to live on the proceeds. And it isn’t simple, because there are many different accounts where one can “put” money.

And even once you figure out how you’re saving money to put away for retirement, it doesn’t do you any good if you don’t know where you’re putting that money.

So if you’ve ever been confused, this article is designed to tell you about the most common types of accounts that are you can use for retirement saving, and why you might want to use one over another (or all of the above).

Why not a regular savings account?

Saving for retirement isn’t rocket science. At its most basic, you put money away, and that money earns interest. Over time, you have enough money that you can live off the interest (as in the 4% Rule), or merely have your money last longer than you do.

So why not put money in a standard savings account? Isn’t that saving for retirement too?

Well yes, it is, but it won’t get you very far.

Most bank savings account earn next to no interest, and even high-yield savings accounts are earning 3-4% at the time of writing. That’s not nearly enough, and most of that will be eaten up by inflation.

The reason not to use a standard savings account is because you need a strategy that earns a higher return than savings accounts can provide. Unless you’re able to go crazy FIRE and put away 40% of your income or something, but I don’t think most people can do that.

Tax-advantaged accounts

The other reason to not go with a regular savings account is because you’ll pay tax on the earning. That will eat up your money too.

Luckily, in the U.S. we have access to what are known as “tax-advantaged accounts”. These are specific types of accounts that are designed to eliminate certain types of taxes, assuming that the funds are used in specific ways (in this case for retirement).

These accounts also have the added benefit of allowing you to invest in financial products that can earn much more than 3-4%.

If you’re wondering when I’m going to mention cryptic terms like 401(k) and IRA, that’s now.

401(k)

Most of you have probably heard of a 401(k), but if you haven’t, it’s a type of account that is tax-advantaged to allow you to save for retirement.

A 401(k) is opened and managed through your job, and it’s funded by taking money out of your paycheck. You don’t make deposits to this account; it’s all done through your work.

Typically, money is funded pre-tax, meaning that it reduces your taxable income on your paycheck. This allows your money to grow faster, because you haven’t paid any income tax on it. You eventually pay tax when you withdraw your money, which can happen without penalty after age 59 1/2.

Traditional IRA

Then there’s the IRA, or Individual Retirement Arrangement. This is a similar type of investment account, but it’s self-directed, meaning that you put the money in yourself, and it doesn’t require being linked to a job or a paycheck.

Like the typical 401(k), this money is pre-tax, but since you’ve already paid tax on it by the time you deposit it, you can get a deduction on your taxes to offset that. And like the typical 401(k), the money grows faster because of this tax status, and you pay taxes when you withdraw (after age 59 1/2 again).

Roth IRA

A Roth IRA is like a Traditional IRA, but it operates with after-tax money. So while you don’t get any tax break in the deposit, the money can grow tax-free, and you never have to pay taxes on any part of it.

The Roth IRA offers certainty (your balance is the money you have), which is why it’s one of my favorite ways for people to start investing. You just put money in and watch it grow. Simple.

Roth 401(k)

I’d be remiss if I didn’t mention the Roth 401(k), a newer (mutant) hybrid of the Roth IRA and the 401(k). It just means that you can fund your 401(k) with post-tax money instead of pre-tax money. It takes a bit more out of your paycheck for the same deposit, but then you don’t have to pay taxes on it later.

Brokerage account

All of the above options allow you to buy mutual funds (or ETFs). If you find and buy low-cost, no-load index funds (here’s an example of one I like), you have a good chance of earning over 8% over the long term. No guarantees, but it’s a bet I’m willing to take.

Technically, you don’t need a retirement account invest in securities. You can open a brokerage account, through something like Vanguard or Fidelity (or even, God-help-you, Robinhood). These types of accounts allow you to buy those same mutual funds and other securities.

The difference is that with a brokerage account, you don’t get any of the tax benefits. And when you sell a security, you have to pay capital gains taxes (most likely 15%). So while brokerage accounts offer tons of flexibility, they come with a lot of downsides when it comes to retirement savings.

Where to start

If you think that these are too many options, that’s understandable. Which one(s) should you use?

I’ve got you on this. I’ve got a plan on which products to use, in what order, and how much to put in each. You can find that info here.

Bottom line

Your best options to retirement saving is one or a combination of the following accounts:

• 401(k)
• Roth 401(k)
• Traditional IRA
• Roth IRA

Personally, I have had all of these, though I’ve rolled over all of my 401(k) accounts to IRAs once I left those jobs.

Hopefully this gives you a good starting point for what it means when people talk about putting away money for retirement.

If things still aren’t clear, feel free to comment, or reach out to me.