When you think about retirement savings, IRAs and 401(k)s likely jump into your head – and for good reason, since they’re the primary types of accounts most people use to save for retirement. Accounts like these replaced the pensions that many workers used to have, allowing – or forcing – you to save (almost) on your own. In this post, I’ll talk about the basics of IRAs and 401(k)s and how these types of accounts are useful to a FIRE saver or anyone saving for retirement, early or not.
What is it about these accounts that makes them so special? Taxes. That’s what. Yes, good old taxes. Ok, not only taxes, but primarily taxes. Because taxes are so important – and because I love talking about them – let’s start with one concept before discussing the other important aspects of 401(k)s and IRAs.
It’s called “realization,” and it doesn’t mean you’re having the realization that this is another post about taxes but that you’ve already come this far so you may as well continue reading. “Realization” is a tax term that refers to an event from which you incur taxation. At its simplest level, realization means that when you sell an asset, you “realize” the gains (or losses) from the sale. “Gain” means the difference between the sales price and the tax basis.
The concept of realization is important to long-term investors. Over time, hopefully, your assets will increase in value. At any given time, you might look at the current value of all the assets you hold and come up with a net worth – and if that net worth is greater than the amount you contributed, you’ve achieved growth. A stock may increase in value each year you hold it. But what’s important is that you’re not being taxed on the growth at any point before you sell the share of stock. If you buy share A in year 1 for $10, and at the end of year 2, it’s worth $20, you’re not taxed on the $10 gain, even though your net worth has increased. You’d only be taxed if you “realize” that gain by selling the share for $20. By selling the share and receiving cash, you “realize” $10 in capital gain, and must pay tax on it.
401(k) Accounts
With the concept of realization firmly embedded, let’s talk first about 401(k) accounts. The 401(k) received such an enticing name for the section of the tax code governing how it works – 26 U.S.C. 401(k). I know I link to a few things here and there, but the actual text of the tax code is probably the least interesting thing you’ll ever come across. For that reason, I won’t link to it, but it won’t be difficult to find.
A 401(k) account must be set up by an employer – you can’t set one up yourself (unless you’re self-employed, in which case there are some options), and contributions come directly from your paycheck. Each year, there’s a cap on how much of your pay you can contribute to a 401(k) – in 2019 it was $19,000, and in 2020 it was $19,500, and so so. If you’re over 50, you can usually contribute more – if 2020, it was $26,000.
The attractive option of a 401(k) is that you can “defer” tax on your salary when you contribute that money to the 401(k) account. If you earn $2,000 every week, and you contribute $500 of that to a 401(k), your taxable salary will be $1,500 (before other adjustments). You don’t get out of paying that tax forever, of course – when you withdraw money from the account in the future, you’ll pay tax on the distributions. In theory, at the time you’re withdrawing from a 401(k) account, you’ll be retired, meaning that you won’t be receiving a salary and will likely have a lower tax rate. Deferring taxes on the income you contribute to a 401(k) benefits from the fact that when actually taxed, it’s taxed less than if you were taxed on that same income at the higher rate to which you were subject while working.
So the tax deferral is one nice thing. But there’s another. Any transactions that occur in the 401(k) account while you hold it – sales of equities, dividends, etc., are not considered to be “realization” events – meaning you won’t pay capital gains taxes on sales or income on dividends. Rather, the only time you pay tax related to a 401(k) account is when you withdraw the money – you’re essentially paying the tax that you deferred from your paycheck years earlier. You don’t incur additional capital gains taxes from the growth. This is why a 401(k) account is a great way to accumulate growth without incurring interim taxes. There are no sneaky taxes associated with a 401(k) like there are when you hold a mutual fund in your brokerage account.
The other beneficial aspect of 401(k)s is that many employers use them as an incentive by “matching” your contributions up to a certain amount. So an employer may “match” your contributions up to either a certain percentage or fixed amount – like say 6% or up to $3,000. This money is basically an additional salary that goes directly into the 401(k) account and grows along with the money you put in. And it’s tax deferred – so you won’t be taxed on it until you withdraw the money.
Of course, with most – but not all – employers, it’s a match, meaning you have to put the money in that they’ll match. They won’t make the deposit if you don’t contribute to the 401(k). Be aware too that sometimes the “match” is vested. So while the employer will put the money in the account, the amount you’re entitled to keep in that account from the employer match depends on how long you work for the company – an incentive to keep you there.
IRA Accounts
An IRA is a concept similar to a 401(k). While you hold money in an IRA account, you do not “realize” any gain. You’re only taxed when you withdraw the money. The difference is that an IRA is an “Individual Retirement Account,” meaning that your employer doesn’t set one up for you – you have to do it.
Similar to a 401(k), an IRA allows you to defer taxes on your income, subject to some exceptions that I discuss below. If you qualify, you can put money into an IRA and then deduct that money from your taxes in the year of the deposit, essentially achieving the same deferral concept as a 401(k).
IRAs, however, have lower contribution limits than 401(k)s. In 2020, the contribution limit was $6,000 generally (or 100% of your income, whichever is less), and $7,000 for those over 50. And unlike a 401(k), IRAs do not allow for any sort of matching because you set them up yourself.
One thing to be aware of with IRAs is that there are limitations on who can deduct contributions. Generally, these limitations depend on how much money you make and whether you already have a work-sponsored retirement plan. For example, in 2020, if you’re single and you have a work-sponsored plan, you can still deduct up to the contribution limit from your income if your adjusted income is less than or equal to $65,000. You can partially deduct contributions from your taxes if your adjusted income is between $65,000 and $75,000. Meanwhile, if your adjusted income is greater than or equal to $75,000, you can’t deduct any money you put into an IRA from your taxes.
If you don’t have a workplace-sponsored retirement plan, however, then you can deduct all the money you put into an IRA from your taxable income, up to the contribution limit. These amounts vary depending on whether you’re married or single, and are continually in flux, so make sure to check them in the year in which you contribute to an IRA.
Even if you’re not entitled to deduct your contributions from your taxable income, you can still contribute to an IRA and achieve tax-free growth while the money is held in the IRA. That means that IRAs can be a valuable tool for tax-free growth (meaning no interim realization events), whether or not you can use them to defer payroll taxes.
Roth IRAs
Finally, there’s the IRA’s cousin, the Roth IRA. A Roth IRA, like the IRA, grows tax-free (i.e., no realization events from the activity in the account); however, you cannot deduct the money you put into a Roth IRA from your taxes when you contribute it. But, the money is tax-free when you withdraw it (assuming it’s a qualified withdrawal – meaning it’s not an early withdrawal). This might be helpful if you think you’ll have higher taxes when you’re older than you do at the time you’re contributing the money. In 2020, the maximum amount you could contribute to a Roth IRA was $6,000, but, make sure to check each year for the applicable contribution limit.
While traditional IRAs do not have income limits – meaning anybody with any income can contribute to them (even though not everyone can deduct contributions from their taxes) – there are income limits on who can contribute to a Roth IRA. In 2020, if you’re single, you can’t contribute to a Roth IRA if your modified income is $139,000 or more. There are different limits for married taxpayers, and also income ranges in which partial contributions are permitted. Because these fluctuate from year to year, make sure you check the contribution limits and income limits in the year in which you’re considering a contribution.
Early Withdrawal Penalties and Required Minimum Distributions
So what’s the catch – does the government really let you grow all this money without any interim realization events? It’s true, these accounts are real. But here’s the critical limitation: for both 401(k) accounts and IRAs, you can’t withdraw the money in the account until you reach the age of 59 ½. This is supposed to incentivize people to save for retirement. If you take a withdrawal before then, you pay a tax penalty in addition to the tax on the money you take out. So if you take a $5,000 withdrawal at age 50, you’ll pay tax on that $5,000 at your standard tax rate, plus a 10% penalty. There are some exceptions to this for hardships, which I won’t list here.
Here’s the other catch. In the year you turn 72, you have to start taking withdrawals. The IRS doesn’t want that money sitting in your account forever without paying taxes on it. Once you hit 72, in that year and each year thereafter, you have to take out an amount called the Required Minimum Distribution (“RMD”), which is calculated based on your life expectancy, and is equal to the amount you’d have to withdraw in your remaining years to draw the account down to $0 in the year you’re supposed to die. You have to take this money out, and pay taxes on it, regardless of whether you actually want or need it.
The RMD is serious – like, really. If you don’t take it out, the penalty is a whopping 50% of the amount you were supposed to withdraw. Which can really eat into your money. The IRS does grant some exceptions to this, particularly since many of these are missed due to the diminishing mental capacity of account holders reaching this age (this is true – I’m not making light of it), but a penalty of this nature is not to be trifled with. Of course, this is some ways down the road and shouldn’t discourage you from contributing to a 401(k) or IRA. And who knows what the penalties and withdrawal landscape will look like in the future.
401(k)s and IRAs for the FIRE Saver
All in all, 401(k) and IRA accounts (and Roth IRAs) are a great way to achieve FIRE or, really, any retirement, so long as they’re part of, and not the only, method of saving. Remember that if you plan to retire before 59 ½, you’ll need the liquidity that comes with a standard account, even if that means paying taxes on interim realization events. Unless you don’t plan to retire until 59 ½, you don’t want to lose chunks of your money with early withdrawal penalties that you incur if you take out money for living expenses.
But on top of your personal brokerage account, having the 401(k) or IRA there is a great source of retirement net worth. As long as you don’t take early withdrawals before 59 ½, it’s a good backup source that will continue to grow even without making any further contributions. If you’re able to retire at 45 or 50, that 401(k) or IRA will continue to grow, and will be there waiting for you when you get older.
With these considerations in mind, it’s important to balance how much you contribute to your 401(k) and IRAs with how much you contribute to your personal brokerage account. You don’t want all your money to be sitting in an account you can’t access until you’re 59 ½ without incurring penalties. You need to ensure that you’ll have enough to live off before hitting that age. Also remember that, because of the longer-term horizon of the 401(k) or IRA, you can get away with contributing less money because it’ll have longer to grow.
If you’re 30 when you start saving, and hope to retire at 45, you need to have enough money in a traditional account to get you through ages 45 – 59 ½. And remember as you save that the money you put into your traditional account will have less time to benefit from compounding returns. So make sure that you realistically project how much you need from 45 – 59 ½ and contribute enough money to get there with the rate of return you anticipate achieving in that time frame.
I hope you enjoyed this post about taxes – I mean, how can you not? In another post, I’ll talk more about the mechanics of 401(k) and IRA accounts, and things you can do with money in these accounts that you can’t do as effectively in your traditional brokerage accounts.
The FIRE Investor's Guide to Early Retirement 