Pick the Right Retirement Account in 2021

10 min readJan 8, 2021

Picking the Right Investment Account

In this blog I’ve highlighted the importance of opening an IRA or 401k before funding a personal investment account. Remember, a retirement account will grow tax-deferred or tax-free, while a personal investment account will accrue yearly taxes that must be paid when you file taxes with the IRS.

Is a 401k Right for Me?

Unfortunately not everyone has access to a 401k. Since a 401k is sponsored by your employer or company, you’ll have to check with your HR department if it’s included in your benefits program. If you know you don’t have access to a 401k, you can just skip down to the IRA section.

If you do have access to a 401k, you should try to get that account up and running ASAP. One of the most important benefits from a company sponsored 401k plan is the possibility of a match program.

A Match Program is an additional benefit that your employer may provide in addition to a 401k. A match program is like the name implies: it is the amount of money your employer is willing to match towards your 401k contribution. This is basically free money.

Let’s use some numbers to demonstrate: as of 2021 the IRS allows individuals to contribute up to $19,500 to a 401k account. This gives you the opportunity to invest a substantial amount of money into a tax-deferred investment account. But not everyone will have $19,500 as disposable income, and contributing that much money could hinder their ability to pay for their bills. A match program from the employer could make it possible for you to meet the $19,500 limit without actually contributing the full $19,500.

One of the most commonly used match programs will enable your employer to match each $1 you contribute, up to a certain amount (typically ranging from 3–6% of your total pay). Aka a dollar-for-dollar match program.

Let’s imagine you have a salary of $60,000 and your employer will match your contributions dollar for dollar, up to 5% of your pay. So if you contribute $3,000 (5% of $60,000) then your employer will also contribute $3,000, for a net total of $6,000. However, if you only contribute $2,000 then your employer will also only contribute $2,000 ($4,000 net total) and you’ll be leaving the extra $1,000 on the table.

There are a variety of different 401k match plans, and some are more generous than others. The amount of money you should contribute to your 401k depends on your unique financial responsibilities and particular plan benefits. However, it is almost always recommended to contribute enough money to receive the maximum match benefit. Only in certain circumstances, such as excessive fees or a severely underperforming investment portfolio, should you consider against contributing to your 401k.

Is an IRA right for me?

If your employer doesn’t provide any 401k opportunity, you should consider opening an IRA account. Other than a 457 or a 403b plan, an IRA is the only tax-advantaged retirement account you can open.

IRA stands for an Individual Retirement Account. According to the IRS, you may contribute up to $6,000 in both 2020 and 2021 towards your IRA. That number may change for 2022.

An IRA is no different than any other investment platform in the sense that you earn money through buying and selling stocks & bonds, earning dividends, and taking advantage of compounding interest!

There’s just one little super awesome detail: retirement investment accounts (including a 401k) will grow unchained by the shackles of taxes! This means that all of the profits made during the many years of investing will not be subject to capital gains taxes! This is a major benefit for those who have many years remaining to invest!

So what exactly are capital gains taxes??

Short-Term Capital Gains Tax: A short-term gain refers to an asset sold less than 1 year of the original acquisition date. Taxes paid on the sale of these assets, like stocks, bonds, and cryptocurrency, are subject to taxes equal to your federal income tax bracket. If you buy 10 shares of $TSLA for $500 each and sell them 1 week later for $600 each, you will have to pay short-term taxes on your $1000 profit.

Long-Term Capital Gains Tax: Taxes that you owe on the sale of assets (stocks, bonds, etc.) after 1 year of the acquisition date. Long-term capital gains tax rates are usually significantly lower than short-term capital gains, giving you a major tax advantage of holding a stock for more than 1 year before selling it. So if you had bought those $TSLA stocks for $500, but instead of selling them 1 week later you hold them for a full year, then you’ll be paying a smaller tax fee on selling them.

As you can see, the financially logical solution is simple: hold stocks/bonds for at least a year before selling them! You’ll owe much less on taxes and keep a larger portion of its growth. The downside to this is the unpredictability of a stock’s performance one year into the future. This is what makes stocks inherently scary. You can speculate, research, and speculate some more and still make a wrong choice. For example, at the start of 2020 $TSLA would fundamentally be a terrible buy strategy, given its price/earnings (p/e) ratio, its financials, and its overbought history. However, buying $TSLA in January of 2020 would’ve grown 800% through 2021! Meanwhile, Boeing (and just about all other airlines) dropped well over 50%, despite having a healthy outlook at the beginning of 2020! We can thank Covid for that.

Time in the market beats timing the market.

Tying this back to the discussion of retirement accounts, the benefit of tax-deferred or tax-exempt growth is astronomical. Within your retirement account, short-term and long-term taxes don’t exist. You’d be able to buy and sell stocks without worrying about the heavy tax burden each year! Not to mention, you won’t be paying taxes on the dividends you earn either!

This highlights the importance of prioritizing your retirement accounts before making contributions to a regular personal investment account. Each year, you can contribute $6,000 to an IRA that will compound without tax burdens, but money contributed into a regular account will be taxed, depending on the sale date of those assets.

What’s the difference between Traditional vs Roth retirement account?

Long story short: Traditional retirement accounts are funded by your pre-taxed income, and Roth retirement accounts are funded by your post-taxed income. You can run but you can’t hide from Uncle Sam.

Here’s a scenario to show how a traditional 401k/IRA works:

Let’s assume you have a traditional 401k account with your employer and you make $60,000 per year. Based on the 2020 tax brackets (with some minor rounding for simplicity):

Scenario 1:
Yearly salary: $60,000 (taxable income)
Traditional 401k Contribution: $0
Marginal tax rate: 22%
Net income: $46,800 (paid $13,200 in income taxes)

You’ve made no contribution to your 401k, which is slightly discouraging, but ultimately your own choice.

But let’s just say you want to contribute your yearly maximum of $19,500 into a traditional IRA (you can make small contributions every pay check to total $19,500) to start investing for your retirement. And because a traditional 401k uses money before they’re subject to income tax, you won’t have to pay taxes (yet) on those hard earned dollars. By the end of the year, you’ll actually be in a lower tax bracket due to having a lower taxable income! Take a look:

Scenario 2:
Yearly salary: $60,000
Traditional 401k Contribution: $19,500
Taxable Income: $40,500 ($60,000–$19,500)
Marginal tax rate: 12%
Net Income $35,640 (paid $4,860 in income taxes)

The two big factors to note here are the differences in net income and 401k contributions. In scenario 1 you’ll have almost $11,000 more in take-home cash, but you’ll have $0 contributed to your investment account. In scenario 2 you’ll take home almost $11,000 less, but you will have the full $19,500 contributed to your 401k! While having the extra money now may be nice, just remember what compounding interest can do to $19,500!

There’s one last thing to consider: because a traditional 401k/IRA is funded with pre-tax dollars, you’ll have to pay taxes on the money you withdraw once you’ve retired. We’ll revisit this soon.

Here’s a another scenario showcasing how a Roth 401k/IRA works.

Let’s assume you’ve decided to open a Roth IRA (or 401k) and you’re ready to fund it. Because a Roth account is funded by contributions of your money after you’ve already paid income taxes, there’s no change in your tax bracket whether you contribute money or not. As a result, the main question is whether or not you can afford to set some aside now. With a $6,000 yearly contribution max, that comes down to about $500 per month. (30 years of compounding interest at an 8% return on a $6,000 yearly contribution will total almost $800,000!!!) Your contributions should be both financially manageable and consistently sent. There’s nothing wrong with starting with only a couple dollars.

But there is an important advantage to consider: because a Roth 401k/IRA is funded with post-tax dollars, you won’t have to pay taxes on the withdrawals once you’ve retired, unlike a traditional account.

So the ultimate question you must ask when choosing between a traditional or Roth is: Do you want to pay taxes now, before investing your money, or would you rather pay taxes when withdrawing your money later, after you’ve invested your money?

Pay taxes now: Roth IRA or Roth 401k

Pay taxes later: Traditional IRA or Traditional 401k

The Verdict

Let’s straighten one thing out first: I’m not qualified to tell you what to do with your money. You need to consult with a tax accountant or a fiduciary advisor if you need financial advice. I just want to help you understand the major differences between the two investment options. It’s not as simple as I’ve outlined it, but it’s also not so complicated as it might seem. It’s time to think about your future!

Contributing to a traditional account has its immediate tax benefits: you can save on taxes now, but you’ll be responsible to pay them when you retire and withdraw. As a general rule of thumb, those who are in a higher tax bracket now will benefit from the tax-deferred contributions. Furthermore, you are more likely to be in a lower tax bracket when you’ve retired than when you are making your contributions now.

With that being said, a Roth account may be a better option now if you are currently in a lower tax bracket now, and expect to be in a higher tax bracket in the future. We don’t know what the tax laws will be in the future, and there’s always a possibility that they will increase.

The bottomest bottom line: it’s better to start either one now and then adjust it in the future. Don’t let paralysis by analysis hold you back. You can roll it over into a different plan later if things change drastically. Better yet you can even use both and course correct later! Start by making it a habit to invest for your future now!

If you want to get started now, but you’re not sure how, you can check my blog on the platforms I use here. My favorite platform for an IRA is Wealthfront; I’ve been using it for almost 5 years! This referral link will waive all portfolio management fees on your first $5,000 invested!

Disclaimers

Remember, investing money in the stock market has its inherent risks, and you could lose some or all of your initial investment. I am not offering advice, I simply try to inspire you to learn more about personal finance. I take no responsibility for your investment strategies and you must do your own research before buying stocks.

Upcoming

A major thank you to everyone for all of your kind words of encouragement. I had no idea this topic would be so well received by everyone. The feedback has been astounding! I’m going to be writing at least 1 per week so you can capitalize on the best 2021 New Years Resolution Goal: Start Investing for Your Future!

These are some blog topics I have in mind that will be coming soon:

Dollar Cost Averaging (how to get the best price for a stock)
Dividend Stocks Vs Growth Stocks (which type of stock is best for you)
How to Speculate Potential Growth
What to do If (When) Stocks Drop

If there is anything else you’d like me to write about, please add it to the comments!