UPDATED VERSION: https://fellow401k.com/blog/retirement-account-order-of-operations/
There’s a lot of different kinds of plans, but let’s cover the most common plans and the life stages of when most people encounter each.
The USA “system” is a social contract between companies / employers, and the US Government. Insurance companies, banks, brokerages, third party administrators… perform what are “government” functions in many countries (such as Europe). They’re heavily regulated industries, and incentives / disincentives are made via our federal tax system and along with penalties and fines. Any debate around national healthcare, retirement plan tax incentives, grants, etc… are in this context.
The benefit of using a “retirement account” is you can grow that money tax free! Many people call this “tax alpha”… which just means that you have more money because you were able to pay less taxes. We all LOVE paying less taxes. I believe many people would prefer to make $50,000 and pay no taxes, then make $100,000 and pay $35,000 in taxes. I have no proof of that, but I believe it to be an emotional truth. Using a retirement account let’s you avoid (or defer) paying taxes for the gains you incur. In a retirement account, this allows the “snowball” effect to keep going without having to stop to refuel & pay taxes each year.
Individual Retirement Accounts
There are individual retirement accounts or “IRA’s”. These always belong to individuals and most of us can put away $6,000 per year into it. Then we choose various assets to purchase with that cash in hopes those assets appreciate. We can hold stocks, bonds, real estate, crytocurrency, rare works or art, shares in a private business, and so on… really anything under the sun. Most of us only invest in publicly traded assets like stocks & bonds.
If we make a good asset decision, our IRA account balances rise and can keep growing without having to pay taxes until we withdraw that money as “income” that we “earned”. IRA’s are easy to open, just go online and type IRA into the search box and boom… you’ll have a plethora of options. IRA’s should be free to open, maintain, and should also have free trading with zero commissions for most assets.
Employer Based Retirement Accounts
Employers must choose one, and only one from the following choices (I’ll omit rarer / outdated kinds of accounts):
SIMPLE IRA: The employer contributes a percentage of your salary into an IRA account they create for you each year. It is usually 3% of your gross income. You can contribute as much into that IRA as you desire… up to an annual maximum of $13,500.
SEP IRA: This kind of employer IRA only allows the EMPLOYER to contribute funds! You cannot put your own money into a SEP IRA. The employer can contribute up to 25% of your gross income each year into your SEP IRA, up to a maximum of $56,000. So if your gross income was $224,000… then you can max out your SEP IRA contribution. This type of account is popular with very small companies or one person companies.
401K: This plan combines elements from the SIMPLE & SEP. Employees CAN contribute their own money, up to $19,500 each year. Employers may or may not match a portion of that contribution. Also, the employer can contribute up to 25% of your gross income each year into your 401K, up to a maximum of $56,000… just like a SEP! However, the 401K is great because employees can also contribute their own money, unlike a SEP and with a higher maximum amount than the SIMPLE!
401K plans have a lot of features, mostly involved with not letting employees access EMPLOYER 401k contributions unless certain conditions are met, such as years of service. Because of this, the IRS has a lot of rules / tests so that owners and highly compensated employees cannot just use the 401K to shelter their own money without benefiting rank and file employees. These features add to costs. Our 401K platform is “safe harbor” and doesn’t require this testing. A Safe Harbor plan requires the EMPLOYER to match the first 3% of employee 401K contributions… then match the next 2% of employee 401k contributions at 50 cents on the dollar.