Understanding U.S. Retirement Investment Accounts

Jason is a financial advisor and Dave Ramsey-trained counselor that blogs over at WorkSaveLive. He aims to educate his readers on a variety of financial topics while sharing his family’s journey out of debt and a weekly delicious recipe. 

Retirement Investment Accounts

Hi Outlier Model readers! Understanding that many of you may be Canadian, Brian and CF requested that I talk a little about the United State’s options for retirement savings.

While I’m fairly ignorant with the way Canada handles things, here in the U.S., saving for retirement is placed squarely on the shoulders of the individual. Yes, we have this wonderfully dreadful system called Social Security where Americans’ paychecks are taxed 6.2% (4.2% for the last 2 years after Obama has tried to help spur the economy) along with their employer also paying the same 6.2% tax which, supposedly, goes directly to the Social Security Income system. That’s a total of 12.4% for those of you not keeping track at home.

Photo Credit: Jake Wasdin via Flickr (http://www.flickr.com/photos/wasdin/2393137359/)

A Social Security Crash Course

While that sounds absolutely amazing to be automatically saving 12% a year towards retirement, that’s not exactly how it works. See, Social Security was started in the 1930s as a way to supplement retirement income. Considering that the government had never taxed for these funds before and had no money allocated to start such a program, it was set up to where taxes from the current workforce were paid to EXISTING retirees.

So, in reality, NONE of the money I’m paying in taxes is going to me at all (or to my own retirement account for that matter). It goes directly to people that are currently retired and drawing Social Security Income. To make matters worse, we have a growing senior population, commonly referred to as the “Boomers.” As these boomers age more of them will start drawing Social Security; well, 20-30 years ago there were 7 working citizens for every 1 retiree, whereas today there are only 3-4 workers per person that’s drawing Social Security Income.

This major issue has resulted in the projection that the Social Security Fund will run at a deficit starting in 2016 and will completely run out of reserve funds in the early 2030s.

Knowing that Social Security Income was merely supposed to supplement peoples’ retirement, and is now in jeopardy of collapsing here in the coming years, that means we have other tax-advantaged options that encourage us to save money NOW, specifically for retirement purposes.

Employer-Sponsored Plans

While many small companies (less than 10 employees and sometimes up to 50 employees) do not offer employer sponsored retirement plans, the majority of the companies here in the U.S. do. Depending on the sector and industry you work will depend on which plan is offered. While the names are different, they’re all pretty much the same thing:

1. 401(k) – private and publicly-trade companies
2. 403(b) – public education and non-profit organizations
3. 457 – government employees

With the 457, 403(b), and 401(k), there are these basic guidelines:

  • Money is added on a pre-tax basis, grows tax-deferred, and becomes 100% taxable whenever you take it out.
  • Employers MAY choose to match a portion of your contributions. In light of the 2008 recession most employers have cut back drastically on what they match, and it’s most common to see an employer match up to 3% of your contributions.
  • Within the 401(k) and 403(b), one cannot withdraw the money until age 59 1/2. While there are some ways that you’re able, for the most part all withdrawals from these accounts will be assessed a 10% penalty and will be subject to normal taxable income when you file taxes if they’re taken out prior to 59 1/2.
  • You’re able to contribute up to $17,000/year or 50% of your income (whichever is less) if you’re under age 50. If you’re over age 50, then there is a “catch up” contribution and can invest an additional $5,500/year.
  • At age 70 1/2, you’re REQUIRED to start taking out money. We call it “Required Minimum Distributions” or RMDs. In essence, the government gets tired of waiting on their tax money, so they require people to starting drawing down these accounts by 2-5% so they can start taxing it.


Individual Retirement Accounts

For people that either (1) are not offered a plan by their employers or (2) have additional money beyond their employer’s match to invest, then we have two primary options available:

1. Individual Retirement Account (IRA)

The IRA is very similar to the 401(k) in that it’s funded with pre-tax dollars, grows tax-deferred, and is 100% taxable upon withdrawal. The benefit to an IRA over an employer-sponsored plan is that there are a VAST number of investment options to choose from.

In the employer-sponsored plans, the company you work for is responsible for choosing “suitable” investments. In which case there are generally only 15-20 different mutual funds that employees are able to choose from. However, with the IRA, you’re able to invest in many other things including the 20,000 current mutual funds available on the market as well as Real Estate and a few others.

2. Roth IRAs

The Roth IRA has really picked up steam over the last few years and is becoming the go-to option for many wise investors here in the U.S. The key with this option is that it’s funded with after tax dollars! Understanding that’s the case, the money grows tax-deferred but is never. taxed. again. You read that right: all of the interest you earn over 10, 20, 40 years will never be taxed!

Of course the government wouldn’t be so kind to do that out of the goodness of their hearts…no, the money will only grow tax-deferred and “tax-free” as long as you don’t touch it until you’re 59 1/2. Considering that these are RETIREMENT investment vehicles, it shouldn’t be a problem for most.

Well, I hope you’re confused because so are many Americans! I run into people every day that have no clue what a 403(b) or 457 is, and many do not understand the differences between the IRA and Roth IRA. Thanks for taking my “US Retirement Investment Vehicle Class,” you will be tested next week.

Posted in: Retirement

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