There is never enough information about two things: is Elon Musk speculating with Dogecoin and what’s the difference between 401k and IRA. In this article we’ll try to approach the second question. Sorry, Elon fans.
Onboarding: Standard brokerage account.
This is the most basic account that you can open to invest money.
- Easy to open (you need to be over 18 and have a Social Security number or a tax ID number),
- No limitations on contributions,
- In general, access to all market tools such as stocks, mutual funds, bonds, exchange-traded funds and derivatives but it might vary across brokers,
- Withdraw money any time,
- Pay full taxes on capital gains.
The rest of the accounts add some perks and limitations. Remember this basic fishbone and let’s continue with two most common investment accounts.
Level 1: IRA
IRA stands for Individual Retirement Account that you would use to save up for your hedonistic retired years when you turn 59,5 years old. It’s similar to the standard brokerage account except for one thing - this is a tax-deferred account, meaning you can reduce your income by the amount of money contributed to the account annually.
Summary: with IRA you save up for your retirement and save on taxes, but it will happen slowly because you are limited with the amount of money you can contribute and you can only withdraw money penalty-free after 59.
Level 2. 401k
Now that you know what is the standard brokerage account and IRA, you will easily make sense of 401k. The distinct feature of this account is that here appears the second party - your employer, who will have to open an account for you (you’ll have to do it through HR) also contribute to it. Let’s compare it with an IRA as a retirement account.
Summary: you get more money into account because your employer-sponsor matches your contributions but you are limited in investment tools and unable to withdraw.
Level 3. Introducing ‘Roth’
Both 401(k)s and IRA have two options: traditional and Roth. Traditional are the ones described above, you contribute pre-tax money. In Roth you contribute after-tax money. So basically, the difference is when you pay taxes: now or in the future.
If you choose Roth 401k or Roth IRA, you won’t have to pay taxes on withdrawal after 59. So the decision depends on your belief (and calculation) what your taxes are now and what it could be in future.
Summary: If your tax rate now is bigger than your tax rate in retirement, it makes more economic sense to open traditional types. If opposite, then Roth.
But let’s be honest, do you remember taxes declining?
There are also accounts that are opened for one’s beneficiary such as education investment account (529) and custodial accounts for kids (UGMA, UTMA), but we were talking about YOU today :)
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