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Alphabet Soup Part 1 – What Accounts do I have and Why?
Acronyms have become a major part of our daily lives. We’re so used to hearing abbreviated versions of long words that sometimes we forget the original meeting, or we just don’t care to learn. The financial world is no different and it’s been swarming with jargon as far back as we can remember with seemingly a new one becoming popular every month.
In this month’s rendition, we’re going to go over some account types and the different accounts you might own. We will discuss certain acronyms and what they mean, along with reasons why you might have one type of account and not another. Let’s begin:
401(k) – Most people’s first investment account and rightfully so. The 401(k) is a retirement plan that is sponsored by your employer. Traditionally, you contribute a percentage of your income and your employer will match a portion of your contribution as well. This account is tax-deferred which means you don’t pay taxes today but you will pay taxes later when you take that money back out of the account. Contributing to this account can be especially helpful when you’re trying to lower your tax bracket or if you just want a slightly bigger tax return. If you wondered the background behind the name, 401(k) is simply the line in the IRS tax code that explains workplace retirement plans. When you hear names that sound weird or complicated, chances are the IRS is involved….shocking.
403(b) – If you read the description about the 401(k) then you’re in luck. There is virtually no difference between the two. The major distinction between a 403(b) and 401(k) is the type of employer sponsoring the plan. A 403(b) is the retirement plan for a non-profit employer like a philanthropy, Government, or school typically. There are a few administrative differences but it doesn’t affect the end user.
IRA or Individual Retirement Account – This retirement account is owned entirely by you. There is no employer sponsor and this makes it subject to different rules and act in a more open structure. The annual contribution limits are lower ($5,500 in 2018) and they can have certain income restraints for contributions as well. Unlike your 401(k) or 403(b) however, this platform is wide open. You can typically choose any investment in the market and keeping a few ‘buckets of money’ under your ownership and direction can prove to be a valuable resource when it comes to your financial future. Money contributed to a Traditional IRA is tax-deferred as well and, like the aforementioned accounts, will be taxed upon distribution as income.
Bonus!
In recent years, the popularity of the “Roth” has boomed and it’s become the go-to account for a savvy investor. A little trick: If you throw the word “Roth” in front of any of these accounts (ie. Roth 401(k), Roth 403(b), or Roth IRA), that means we’re reversing the tax effect. Roth means the account is classified as tax-free, although we don’t get to enjoy the tax write off today. Your Roth contributions are taxed when they come to you as income, so no need to worry about future tax-brackets for this account.
Maybe your employer just added a Roth option onto your 401(k), or maybe you are thinking of starting one yourself. Either way, diversifying your accounts can make a huge difference to your end goals and understanding, and taking advantage of, these differences is an easy way to stay on top of your game.
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