Retirement Accounts
I have been in the process of consolidating some of my financial accounts (a more detailed post on this to come later), and I’ve had quite a few questions come up around my retirement accounts. When I started at Cisco Systems, I was hired as a contract employee, and I remained on contract for about six years. During that time, I did not have an employee-sponsored 401(k) plan, so I setup my own IRA (Individual Retirement Account) through Wells Fargo. I initially opened a Traditional IRA and later on opened a Roth IRA, which I only contributed to briefly before I was eventually hired as a benefited employee at Cisco. Once at Cisco, I was offered a 401(k) plan. I didn’t really understand much about these accounts when I opened them, and I only opened them after someone suggested I do so. I want to take my learnings and share them here, in hopes that it may help others understand these different types of accounts and how they apply to their retirement situation.
There is a lot of terminology in this post, so I am adding a brief glossary here:
IRA: Individual Retirement Account
Contributions: the money that is added to your account
Investment: where the money is invested (e.g., stocks, bonds, index funds, etc.)
Earnings: this is the amount of money made on an investment (e.g., interest, dividends, the money earned from selling stock)
Distribution: withdrawal or payout from an IRA
Qualified event: events that “qualify” you to take money from your account without penalties (i.e. you are 59.5 years old, you become disabled, a first-time home purchase, higher education expenses, etc.)
I am going to detail below a few of the common retirement account types. There are other (I believe less common) types of accounts, but I’m not familiar with those and won’t be covering them in this post. I’m going to start with the 3 different IRA accounts:
Traditional IRA:
There are contribution limits to this account, meaning you can contribute up to a certain amount of money into this account each year. For 2024, that amount was $7,000 for people under 50 years old or $8,000 for people older than 50 years.
There are no income limits to contribute to a Traditional IRA, meaning no matter your income level, you can aways contribute to this account type (up to the yearly contribution limits).
You may be able to take a tax deduction on the amount you contribute each year, depending on your tax filing status and income. For example, whether you file as Married or Single / Head of Household, this may affect your ability to take a deduction. The specific rules can be found online at the IRS website.
If you qualify for the tax deduction, you are deferring your taxes on this money until you take a distribution. Meaning, you will be required to pay taxes on your contributions and earnings at that time.
Penalties are incurred for taking any early distributions (before age 59.5), unless you have a qualifying event (e.g. higher education expense).
Roth IRA:
The yearly contribution limits are the same as the Traditional IRA ($7,000 or $8,000 per year, depending on age).
Unlike the Traditional IRA, there is an income limit to the Roth IRA, meaning you cannot contribute to this account if you make more than the income limits specified on the IRS website. For example, if you are Single / Head of Household with an income of more than $161,000 per year, you cannot contribute to this account type.
Contributions do not qualify for a tax deduction.
Since contributions are made after-tax (and do not qualify for a tax deduction), you can withdraw contributions tax and penalty free at any time (as long as the account is at least 5 years old).
The biggest advantage of the Roth IRA over the Traditional IRA is that all contributions and earnings can be withdrawn tax free with a qualified event (e.g. you are 59.5 years old). The Roth IRA allows your money to grow tax free, whereas you will be taxed at the time of distribution for the Traditional IRA.
Same as the Traditional IRA, any early distributions will be penalized unless it’s for a qualified event.
Backdoor Roth:
This type of retirement account is for people who exceed the income limits for a Roth IRA.
The contribution limits are the same as Traditional and Roth IRAs ($7,000 or $8,000).
Contributions are made to a Traditional IRA (which has no income limits) and are then converted into a Roth IRA.
The benefit of this account is the same as stated for the Roth IRA, your money grows tax-free. You will not pay taxes on any distribution for a qualified event.
This account is a way to get around the income limits of a standard Roth account while getting the same tax benefits.
One important thing to mention for all of the accounts I’ve mentioned here — making a contribution does not necessarily invest the money. After the account is funded with cash, you must choose the specific investments (another post on investment types coming soon).
Additionally, it’s important to note that some investments pay dividends and interest, and that may come back into your account as cash (unless you set it up to automatically re-invest). It’s important to check your account for uninvested cash that may just be sitting in your account, because you’re not going to make money on cash just sitting there! This happened to me recently with my Wells Fargo Traditional IRA that I had been ignoring for a number of years. I was unaware that I had been receiving a small amount of dividends from my investments; the money was accumulating in my account and not being reinvested. That was definitely some wasted earnings potential!
It should also be noted that although I opened my IRA accounts through Wells Fargo, there is a large selection of banks and investment firms where people can open these account types.
Lastly, I will talk about:
401(K):
This is an employer-sponsored account and cannot be opened on your own (unlike the IRA accounts above).
The contribution limit for a 401(k) in 2024 was $23,000.
Employers can match contributions, i.e. Cisco matches up to 4.5% of my contributions. This amount is is in addition to the $23,000 individual annual contribution limit. The total maximum amount between employee and employer is $66,000 per year (unless you’re older than 50 and need catch-up payments).
Contributions can be deducted from your earned income, lowering your taxable income and taxes.
Same as the IRA accounts, investments must be chosen. In my case, I chose a target-date fund, meaning you select your retirement year and the fund will be managed more aggressively when you’re younger and more conservatively as you get closer to retirement. But, you can also select other standard investments like bonds and index funds.
Similar to a Traditional IRA, since taxes are deferred, you will pay taxes on distributions (contributions + earnings).
That’s a lot of detail and a lot of jargon, and there’s even more I could have written. It’s been a process to wrap my head around all of the definitions and rules, and I’ve had to ask the same question multiple times to truly understand some concepts; the tax implications are hard for me to conceptualize at times. But, I’m learning and I’m asking the right questions! I plan to compare these account types to a standard investment / brokerage account and detail the differences in a future post. In the meantime, I hope this is helpful in learning about the most common retirement accounts, the rules of each, and some of the benefits.
