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At some point, most of us realize that we need to start saving for retirement. For some, it comes from seeing the struggle of a parent or a grandparent trying to make ends meet on Social Security alone. For others, it comes from a vision of a great retirement, or even retiring early. In any case, saving for retirement is a vital part of almost everyone’s financial journey.

The process of actually saving for retirement isn’t so clear, however. There are options in abundance out there for most people to save for retirement. Virtually all Americans have access to traditional IRAs, and most Americans have access to a Roth IRA, too. Many Americans also have workplace retirement plans, and there’s always the ability to just put your money in an ordinary investment account.

How does a person navigate these options? What’s the difference between them? Let’s dig in.

In this article

It’s the taxes!

Almost all retirement accounts for individual savers have a few key features in common. You deposit money from somewhere, either directly from your paycheck or your checking account, and you usually agree to have this done automatically on a regular schedule. You choose investment options for that money. Then, it sits there until you need it in retirement (or in a serious financial crisis).

The big difference between the various retirement account options is taxes. Here’s how.

Taxes in a normal investment account

Investment accounts are set up directly with an investment firm, like Fidelity, Vanguard, Charles Schwab or Edward Jones. In a normal investment account, you deposit money directly from your checking or savings account. Remember, money in your checking account or savings account is money you’ve already paid income taxes on (or soon will). Once the money is in an investment account, you choose how it’s invested: stocks, bonds, index funds, whatever you like.

As long as you leave it alone and let it grow without selling it, you don’t owe taxes on that investment. However, it may generate income for you in some way, such as dividends. You will owe taxes on dividends and other income in the year in which you earn it.

When you sell an investment in a normal investment account, you owe taxes on how much you earned from the sale. So, if you initially bought an investment for $5,000 and you sell it for $8,000, you’ll owe income taxes on the $3,000 you made, even if you immediately invest it in something else. This is called capital gains, and it’s taxed at the current capital gains tax rate. As of 2020, short term capital gains (investments you held for less than a year) are taxed at a normal income rate, while long term capital gains are taxed at a lower rate.

  • Pros: Very simple, no requirements, you pay lower taxes on investments you hold for more than a year
  • Cons: Dividends and other income are taxed as you earn them, no other tax benefits

Taxes in a traditional 401(k)/403(b)

For many people, the easiest option for retirement savings is a workplace retirement account, usually called a 401(k), 403(b), or TSP. These plans work similarly.

With this type of account, money is taken out of your paycheck before taxes. This means that your taxable income goes down for the year if you use this type of retirement plan. You’ll bring home a smaller paycheck (because some of it goes directly into your retirement account), but the reduction in your paycheck will be less than the amount you contribute (because you owe less taxes this year). Some employers actually match your contributions up to a certain amount, immediately adding 50% to your money or even doubling your money.

Once the money is in the account, it’s invested according to your instructions when you set up the account. If investments in your account earn income, it stays within the account and is reinvested according to your instructions and you do not owe taxes on that money. The only time you owe taxes on a traditional 401(k) or 403(b) account is when you withdraw money.

If you withdraw money from this account when you retire, it’s treated like normal income and it’s taxed just like you would see if it were a normal paycheck. Usually, taxes are withheld as you withdraw the money to make filing your taxes easier at year’s end. The advantage is that usually in retirement your income level is lower, so the amount taken out for taxes is much smaller.

The contribution limit for the 401(k) and 403(b) is quite high, at $19,500, with a $6,500 additional catchup if you are 50 or older.

  • Pros: The simplest option for those who have it, you can rebalance without tax worries, your tax rate in retirement is likely to be much lower than it is during your career, your employer might match contributions
  • Cons: Withdrawals are taxed as regular income; if you take money out of the account before retirement, there can be a 10% additional penalty

Taxes in a traditional IRA

Another option to consider is a traditional IRA. You can set up a traditional IRA on your own at an investment firm. You deposit money into the account from your checking account and choose how it’s invested. Once money is in the account, you can buy and sell it as you desire without any tax consequences, which means you can rebalance as you desire. Also, any income that your investments might earn stays within the account and isn’t taxed until you withdraw it.

One advantage of a traditional IRA is that your contributions to it are tax deductible, provided you meet the income limit. So, if you’re claiming individual deductions on your taxes (for most people, this usually happens while they’re paying off a home mortgage), you might be able to also deduct your traditional IRA contributions.

IRAs have an annual contribution limit. In 2021, that limit is $6,000, or $7,000 if you’re 50 or older. This is a limit across all of your IRAs, traditional or Roth.

When you withdraw money from a traditional IRA when you are retired, the withdrawn money is taxed as normal income, just like withdrawals from a 401(k) or 403(b). However, as noted there, your taxable income level should be lower in retirement, and thus you’ll pay a low tax rate.

  • Pros: Easy to set up, you can rebalance without tax worries, your tax rate in retirement is likely to be much lower than it is during your career, you may be able to deduct contributions in the year you made those contributions if you have enough other deductions
  • Cons: Withdrawals are taxed as regular income; if you take money out of the account before retirement, there can be a 10% additional penalty

Taxes in a Roth IRA

A Roth IRA is much like a traditional IRA, with a few key changes. Roth IRAs are available at most investment firms and you can easily set one up yourself. As with a traditional IRA, you make contributions from your checking account. However, your contributions are not tax deductible, which is only really important if you have a lot of other deductions anyway.

Once your money is in a Roth, you can buy and sell investments within the account without tax penalty, and any dividends or other income you earn don’t trigger taxes, either.

IRAs have an annual contribution limit. In 2021, that limit is $6,000, or $7,000 if you’re 50 or older. This is a limit across all of your IRAs, traditional or Roth. Furthermore, you can only contribute to a Roth IRA if your income level is low enough. In 2021, the limit for partial contribution is $140,000 of modified adjusted gross income (MAGI) for single filers and $208,000 for joint filers.

It’s when you withdraw money from a Roth that they really become amazing. For starters, you can withdraw your contributions at any time without penalty, so if you’re in a pinch, you can get those contributions back (though you can’t later decide to put old contributions back into the account again). Here’s the real amazing part, though: When you’re of retirement age (59 1/2 or older), you can withdraw your earnings from a Roth IRA, and it’s not taxable income

A Roth IRA can be a good option if you anticipate having more income when you retire or if you anticipate a rise in taxes.

  • Pros: Roth IRAs are easy to set up, you can rebalance without tax worries, you can withdraw contributions without penalty, no taxes on gains if withdrawn in retirement
  • Cons: Income limit, limit on annual contributions, contributions not tax deductible

Which option should you choose?

If you have a workplace retirement plan and your employer offers matching contributions, that’s going to be your best option every time. Contribute enough to that plan to get every dime of matching. That matching money blows away the tax benefits from other accounts.

There’s also the Roth IRA; contribute as much as you can, up to the annual limit. If you want to contribute more, use your workplace retirement plan, if available.

Or consider a traditional IRA. In this situation, it’s very similar to your workplace retirement options, but you’ll likely have more and better investment options. If you want to contribute more than the IRA annual limit, use your workplace retirement plan, if available.

Only use a normal investment account for retirement if no other options are available to you.

This content is for informational purposes only and is not intended as professional advice. We welcome your feedback on this article. Contact us at inquiries@thesimpledollar.com with comments or questions.