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Monday, January 10, 2011

Retirement Accounts (IRA's, 401k's...etc)

I recently had someone ask me about retirement. Retirement is a pretty broad topic to touch on. I may make this multiple posts over time, but for now I'll touch on the most common facet of retirement. Most people working corporate jobs have access to a 401k, SEP or profit sharing plan. For others its access to an IRA.

Thats a whole lot of acronyms and numbers. Lets define 2 of them and discuss them.
  1. 401k - name is derived from internal revenue code 26 U.S.C 401(k)
  2. IRA - Individual Retirement Account
What is the purpose of an IRA or 401k?

The purpose of an IRA or a 401k is to allow for you to save for retirement tax deferred. Also, you can invest in stocks and bonds...etc.

What is the benefit to saving money into a "retirement account" versus a savings account or a standard brokerage account?

Saving money into a retirement account allows you to (1) possibly decrease your taxes (2) defer taxes on the growth of your money.

Can you give me an example of what you mean?

For example, if you make $50,000/year and save/defer $3,000 in an IRA or 401k, your taxable amount that year would be $47,000. This is good because it helps reduce your taxes for that year. In some cases deferring money can actually keep you at a lower tax bracket.

Ok, great I know what you're talking about, but whats the difference between a 401k and an IRA?

Fundamentally the two allow you to do similar things - save for retirement and defer your taxes on the money saved in the retirement account. The real major difference is the contribution limits and investment choices. A 401k usually has limited investment choices ranging from a few to dozens. An IRA is more flexible and you can choose the investments. 401k's by employers typically match contributions (you'll need to check your company's policy to determine how much and what the vesting period is.) IRA's do not match. Most importantly though, the limits are different. The maximum you can contribute to a 401k for 2011 and have it deducted from your gross salary is $16,500 for those under 50. For those 50 and above, you can contribute $22,000. IRA's on the other hand only allow $5,000 for those under 50, for those above 50 the limit becomes $6,000.

Other information regarding IRA's and 401k's

Keep in mind that in order to receive this benefit of deferring taxes on the contribution and the growth there has to be some "catch." The catch is that you cannot take the funds out and use it until 59.5 and after. If you take it out prior to 59.5 there usually is a 10% penalty on top of paying ordinary income tax on the funds. There are circumstances where you can take the money out prior to 59.5 such as disability, college, first time home buying, medical bills while unemployed...the list goes on.

In general, there are advantages and disadvantages to contributing to retirement accounts. One thing that might be good practice is to have 3-4 months of savings before you start to contribute significantly to your retirement accounts. Retirement savings are a great way to start to sock away for retirement, but for most people this should be the only savings you have for retirement.

Just as a disclaimer, this post is not meant to be specific investment advice. Please speak with your CPA, attorney and financial advisor regarding any legal/professional advice.


  1. Great job explaining 401k/IRAs, Ben!!

  2. You should make this a series...I don't get what to do with my stocks, espp and 401k plans. LOL. I just pretend like I know how to invest.