Saving for Retirement: Mechanics

Once you understand these four terms

you will be able to understand the mechanics of most retirement accounts.

Pre-Tax Contribution

This is as simple as it sounds.  Pre-Tax retirement contributions deducted from your paycheck pre-tax.  If your gross income for the month is $3,000 and you contribute $300 to retirement then tax is calculated on the remaining $2,700.

Post-Tax Contribution

As you may have guessed, this is the opposite of pre-tax.  In the previous example, the tax would be calculated on the $3,000, and then the retirement contribution would be deducted.

Tax-Free Growth

In this type of account, any earnings on the investment grow tax-free.  For example, if you contribute $500,000 to retirement over the course of your career and it grows to $700,000 the $200,000 of gains is tax-free.

Tax-Deferred Growth

This type of account grows tax-deferred meaning the tax liability would be deferred until it was withdrawn at retirement.

To put this in perspective…

Pre-tax contributions grow tax-deferred.  That is because the money going into the account has not been taxed.  Back to the example, if $500,000 were contributed before tax and it grew by $200,000 then none of the $700,000 would have been taxed.  That tax is paid as withdraws from the account are made.

On the other hand, post-tax contributions grow tax-free.  This is a huge bonus.  In the example, if $500,000 were contributed post-tax the $200,000 would grow tax-free.  This means there would be no tax liability on the $700,000 at retirement.

So, how do these terms apply to the various retirement accounts?  To keep this simple, we will only consider two types as this will cover most situations.

Roth IRA

This is a great invention.  It is a post-tax, tax-free account.  Individuals take the initiative to contribute to this type of account themselves from their take-home pay.  It then grows tax-free.  At the time of this writing, the maximum amount an individual can contribute to a Roth IRA annually is $5,500 or $6,500 if you are age 50 or older.

401K

There is nothing magic about this name.  It simply comes from section 401K of the federal tax code.  This section defines how employers may contribute to their employee’s retirement account.  This type of account is a pre-tax, tax-deferred account.  Most employers offering this type of account also offer matching funds.  For example, an employer may match 100% of the first 5% you contribute.

So what retirement strategy should you use?

1. If you qualify for a 401K and your employer matches contributions, that is free money.  Do not leave this on the table.  You should contribute to your 401K first up to the employer’s match.  In the previous example, you would contribute 5% to get the full match.
2. Move to tax-free growth as quickly as possible.  Contribute to a Roth IRA until you hit the 15% of your gross annual income or the annual contribution limit.
3. If you hit the annual limit and have only contributed 13% of your gross annual income, jump back to the 401K to round out the remaining 2%.

To summarize…

Get the employer match in the 401K first, and then max out the Roth IRA.  If you still have room to contribute go back to the 401K.  This may mean that you are contributing 7% to your 401K even though your employer only matches 5%.  This is no problem.  The goal is to get to 15% while getting the match, getting the most tax benefit.

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