Money Rehab with Nicole Lapin - Choose Your Fighter: 401k or Roth IRA

Episode Date: June 30, 2021

401k... IRA… alphabet soup… help? Nicole breaks down the difference between the darlings of the retirement world, and how to know which option is right for you. Learn more about your ad-choices at https://www.iheartpodcastnetwork.comSee omnystudio.com/listener for privacy information.

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Well, it doesn't. Charge for wasting our time. I will take a check. Like an old school check. You recognize her from anchoring on CNN, CNBC, and Bloomberg. The only financial expert you don't need a dictionary to understand. Nicole Lappin. These days, we have a lot of choice when it comes to savings plans for retirement.

Back in the day, though, it was Social Security, Medicare, and pensions. And that's it. Today, there are eight different kinds of benefits plans that your employer can offer. But employers push the choice onto you because they don't want to be on the hook for liability. That's a huge responsibility. So how do you make the decision? Charlie writes in with this question. Hey, Nicole, I'm honestly just completely fucking lost when it comes to retirement plans. Most of my friends have a 401k, but my brother has a Roth IRA and feels so strongly about it. Which one is

better? And how do you know they're different? Well, Charlie, I know this can be super overwhelming right now, but I'll take you through it. Here are the players. A 401k is a retirement account established by employers for employees that's tied to the stock market. If you're at a company that offers a 401k, you can make contributions before the money hits your paycheck and then your contribution is invested in an account with your name on it. People get super excited about 401ks because sometimes the employer can make a matching contribution to your account, which is like getting free money. And any money you contribute goes in before taxes. However, don't think this money is tax-free because you do have to pay tax when you take the money out. If you take it out before you're 59 and a half, yes, that's really

the number the IRS came up with, you have to pay penalty fees. 401ks do tend to be the most popular retirement plan, but that doesn't necessarily mean it's the best one for you. Remember, trusting your employer with your money is trusting your employer with your money. Why not trust yourself instead? Most people don't even realize that 401ks aren't actually meant to be retirement accounts for your entire retirement.

They're technically profit-sharing accounts because they allow you to have 100% of your money in your company's stock, which you should never do. Hello, WorldCom, Tyco, Enron, Lehman Brothers folks. Maybe it's just me, but the basic idea of having your retirement and your job so closely linked seems wrong. After all, familiarity might breed contempt in family, but it breeds blindness in business. If you put all your money in your company's stock and the company goes out of business, your livelihood is doubly screwed. Now with losing your job and later with losing your retirement savings. Let me repeat, 401ks aren't and were never intended to replace your entire income when you retire. It's just how we started using them once traditional

pensions, which are meant to replace your income when you retire, started becoming less common. Pensions would guarantee you money when you retired, and that put the burden on your employer to make sure the money was there when you need it. Nowadays, 401ks are cheaper for employers to run because they put the burden on you. A 401k is right for you if, number one, your employer matches your contributions. Number two, you need something easy or you won't save it all. No shame if that's you, just be honest. Number three, you want to go crazy with your contributions. The limits for a 401k in 2021 is $19,500 for your

personal contributions. And that's a lot higher than an IRA, which we will get to in just a sec. Number four, you may need to borrow from yourself. Now, you can take up to 50 grand or 50% of your balance, whichever is less, if you need it for an emergency without penalty as long as you can pay it back within five years. Quick side note here, try your hardest not to exercise this option, especially if you have a precarious work situation. Because if you lose your job, you have to pay what you borrowed back within 60 days or it will be considered a default and really hurt your credit score big time. But just know that the loan option is there if you absolutely have no other choice. Well, that's that. A 401k is not right for you if, number one, you don't have six to nine months of emergency reserves in the

bank. Yes, you need to save for retirement, but you need liquidity first. You can't pay for stuff at the grocery store with a 401k. Number two, your employer doesn't match your contributions. Many do, but not all do. So definitely check. Many companies actually suspended 401k matchings as a cost-saving measure during the pandemic. Number three, you have a significant amount of credit card debt. Paying down debt is a form of long-term savings because if you don't pay it down now, you'll pay more and save less later. Avoid the potential avalanche of debt, especially credit card debt, and tackle the mountain of interest accumulating bills first. Number four, you want freedom of choice on fees and investment options. Since this is your employer's show,

they pick the plan and they pick the fees. You get a few options, but that's basically it. pick the plan, and they pick the fees. You get a few options, but that's basically it. Even if the fees seem pretty small at the time, they definitely add up, and you may be able to do better if you feel adventurous and studious enough to tackle it on your own. Hold on to your wallets, boys and girls. Money rehab will be right back. Now for some more money rehab. So how did you do? Are you swiping left on the 401k? All right, well, let's introduce you to another candidate, the IRA. IRA stands for Individual Retirement Account. Similar to a 401k, you can open an IRA with pre-tax money and you don't have to worry about paying tax until you need to use the money. But unlike a 401k, an IRA is not offered through an employer. You have to set it up yourself and you keep that account forever and

always no matter where you work, hence the individual part in the individual retirement account. IRAs are kind of all the rage these days. But how do these darlings of the retirement savings world actually work? I found out by opening one. When I was at CNN, I started a 401k because it was recommended to me. I never stopped to even consider that there were other options. And now, of course, I wish I had. Live and learn from me, folks. When I finally did look into other options, I found that there were three major pros of an IRA for me. Number one, the money I put in actually reduced my taxes. At the time, I was in the 25% tax bracket.

So when I put $6,000 into my IRA, my taxable salary or income was reduced by that amount. That meant my tax bill was reduced by a cool $1,500, which is 25% of six grand, which is nice. by a cool $1,500, which is 25% of six grand, which is nice. I mean, it's not that I saved that money per se, since tax refunds are technically, you remember this, just your money coming back to you, but I didn't have to pay more for it. Number two, I could still have a 401k, and if I had enough money to max both of them out, I could. Number three, the IRA rules for withdrawal aren't super stringent. If you are using the money for medical expenses, to buy a house for educational purposes, you can even skirt around that 10% penalty fee.

While IRAs have a lot of pros, there is one notable con. You are limited by the amount you can contribute each year, and that contribution limit is lower than 401ks by a lot. In 2021, you can only contribute $6,000 if you're under the age of 50, $7,000 if you're older than 50. You can do all of this at once, or you can do it at any time up to tax day following the year for which you're making that contribution. So for example, you have until April 15th of 2022 to make the contribution for 2021, assuming, of course, that's the actual date it's going to be next year. Once you max out the IRA, as you should try to do annually, the show's over until next year. So having an IRA alone isn't going to catapult you into retirement rock stardom.

When I started working for myself, I really didn't know where to start when setting up an IRA. So here are the steps that I took. Step one, call companies that offer IRAs like Vanguard or Fidelity. You can also do this online. Step two, go through the account setup process. Also easily done online. Step three, decide what to invest the money in. Index funds and chill.

Step four, fund the account. That is, put your money in and voila, you have an IRA. Step five, claim the amount you contributed as a deduction on your tax return. But wait, there is more. I have been saving the very best for last, the superstar of the team, the Roth IRA. Roth IRAs, or just Roths for short, are a lot like traditional IRAs, except you put money in after you pay tax. So unlike a 401k or traditional IRA, you don't have to pay tax on the money when you take it out when you're an old sexy lady or an old sexy guy because you already paid for it. This makes your nest egg a lot easier to account for over time. I mean, we can't see into the future. We can't predict what tax rates

are going to be in the year you retire, but tax rates will likely increase. So those investing in a 401k or IRA have this unknown tax bill looming, while those with a Roth IRA are going to have no surprises. The rule in 2021 is that you're eligible for a Roth IRA if you make less than $125,000 as a single person. So if you're given the option, you should absolutely put money into a Roth. Don't hesitate. Pause the podcast right now and please open up an account. Seriously, yes, you are paying taxes on whatever you're contributing now, but you're paying it before your money has even grown. When you pay taxes later, like you do with a 401k or a traditional IRA, you're going to be paying taxes based upon the amount that it has grown to. Assume you have $80,000 in the account when you want to take the money out decades from

now. With a traditional IRA, that $80,000 is all taxable as ordinary income, which is the same rate that you pay tax on for the salary you make. If you assume a 25% tax rate, the amount of money you really have after tax is $60,000. In other words, you're going to have to give $20,000 to the government before you can use it for all the fun things you planned for. With a Roth, you get to keep the full $80,000. That's right. You don't have to give $20,000 to the taxman when you turn 59 because you already paid taxes on the money when you put it in the account in the first place. The only thing you gave up on to get this awesome deal was a tax deduction when you made the original contribution. You can't actually deduct the contribution to Roth IRAs

like you would if you qualify for a traditional IRA. That would be double dipping. Sticking with our assumed 25% tax rate, you paid an extra $1,500 of tax when you started, 25% of six grand for the privilege to not pay $20,000 later. That's a very, very good deal if you ask me, which you are because you're listening to me right now. So don't pass up on making Roth contributions if you can. Here's today's tip you can take straight to the bank. A 401k can be good. It can be great, but it all depends on you, your debt situation, your goals, and your company plan.

If your employer doesn't match contributions or there are high fees involved or the plan doesn't come with the right investment choices for you, you might want to rethink it. If you're eligible for a Roth IRA, start one today. The best time to do this is when you're in a lower tax bracket, because you'll pay less now and still not a later. Money Rehab is a production of iHeartMedia. I'm your host, Nicole Lappin. Our producers are Morgan Lavoie and Catherine Law. Money Rehab is edited and engineered by Brandon Dickert with help from Josh Fisher.

Executive producers are Mangesh Hatikader and Will Pearson. Huge thanks to the OG Money Rehab supervising producer, Michelle Lanz, for her pre-production and development work. And as always, thanks to you for finally investing in yourself so that you can get it together and get it all. You spend my money, money, money. You spend my money, money. You spend my money, money, money. Youend my money, money, money. Spend my money, money, money.