By far the most common questions we get at Motley Fool Answers have to do with the alphabet soup of retirement accounts: 401(k)s, 403(b)s, IRAs (both the traditional and Roth flavors), and how to make the most of these investment vehicles. Today's episode (which you can also download for free on iTunes and Stitcher) will help you rock your retirement accounts and avoid common mistakes people make with them.
Transcript
ALISON SOUTHWICK:
This is Motley Fool Answers. I'm Alison Southwick and I am joined by Dayana Yochim and Robert Brokamp, personal finance experts here at The Motley Fool.
Most of the questions we get here at Motley Fool Answers are about your retirement accounts -- your IRAs and your 401(k)s -- so today we're going to kick off the conversation by tackling the basics of retirement accounts and calling out some of the biggest mistakes or misconceptions that people have/make. So by the end of the show, you'll know the difference between a Roth and not-a-Roth, and how to avoid some common pitfalls in your retirement account.
First let's get into the basics of retirement accounts to get us all on the same page, and to kick it off we have a question from Melissa. She says, "I'm in my 20s and am finally eligible for my employer's 401(k) plan." Yeah!
ROBERT BROKAMP:
Yeah! I love how she says I'm in my 20s and finally -- finally -- I'm eligible.
ALISON SOUTHWICK:
"I've been dreaming of this day since I was a toddler."
ROBERT BROKAMP:
I love her.
ALISON SOUTHWICK:
That's very strong. I love her, too.
DAYANA YOCHIM:
I admire her, but I feel like I need to get to know her a little bit better.
ALISON SOUTHWICK:
All right. All right, Melissa. You're in your 20s. We've decided you're in your 20s. You're eligible for your employer's 401(k) plan. Robert loves you.
She says, "I signed up last night and decided to contribute about $100 a month for now. No clue if my employer matches contributions or not." Go talk to your HR person. They'll tell you.
"But I'm wondering if I should sign up for an IRA, too. What are the differences between a Roth and a traditional IRA, and should I contribute more money to the 401(k) or the IRA? Are the fees higher for one of those? And also please just use my first name if you answer my question in a future podcast. Thank you." Melissa...
ROBERT BROKAMP:
Blank.
ALISON SOUTHWICK:
Gilder ... steen. All right. So let's get...
DAYANA YOCHIM:
That was a very robust question.
ALISON SOUTHWICK:
It was!
DAYANA YOCHIM:
She kind of covers everything you need to know about IRAs...
ALISON SOUTHWICK:
Which is perfect, because that's what we're going to do. We're just going to go through her questions and...
ROBERT BROKAMP:
And you'll know everything you need to know about retirement accounts, in general. Not just IRAs.
DAYANA YOCHIM:
That's right.
ALISON SOUTHWICK:
So, let's get to the basics, here. Robert, what is an I-R-A?
ROBERT BROKAMP:
An IRA is a retirement account. You deposit cash and then you choose what you want to invest that cash in. You don't have to be connected to a particular job. You just have to have earned income. Anyone can open an IRA except for maybe wealthier people older than age 70-1/2. But most people, as long as you're working, can contribute to an IRA.
ALISON SOUTHWICK:
OK. And an IRA actually stands for not what our listeners probably think it does.
ROBERT BROKAMP:
Well, if you look at the definitive IRS publication for IRAs, it says IRA stands for individual retirement arrangement.
DAYANA YOCHIM:
It's not "account."
ROBERT BROKAMP:
Not account.
ALISON SOUTHWICK:
I thought it was account.
ROBERT BROKAMP:
That said, there is an individual retirement account, but it's a subpart of the arrangement and the IRS calls that an IRA, too. Very confusing.
ALISON SOUTHWICK:
Yeah. So I have an IRA. What am I actually buying?
ROBERT BROKAMP:
Well, you choose. You decide which investments. Now there are rules about which types of investments you can own. Essentially it's the stuff everyone's familiar with -- cash, stocks, bonds, mutual funds, exchange-traded funds -- pretty basic stuff. There are some things you're not allowed to own in an IRA. For example, it specifically states in the IRS publication that you cannot hold alcoholic beverages in your IRA listed among collectibles like antique trucks and so forth...
DAYANA YOCHIM:
They leak all over the place ... the alcohol.
ROBERT BROKAMP:
Yeah, the soggy IRAs. Really embarrassing.
ALISON SOUTHWICK:
It even makes a fool of itself at parties.
ROBERT BROKAMP:
Now what some people don't know is that within something called a self-directed IRA -- which is kind of special and you usually can't get these through Vanguard, Fidelity and those bigger companies -- you actually can own interests in business, farmland, private mortgages, some of this stuff. But the rules are so complicated that if you don't do it correctly, the whole thing can be considered a distribution and you'll pay taxes and penalties. So for most people, stick with stocks, bonds, cash, and mutual funds.
DAYANA YOCHIM:
Stick with the basics.
ALISON SOUTHWICK:
But an IRA, itself, is not an instrument...
DAYANA YOCHIM:
No. And that's another common misconception. People think, "This IRA is doing well or that IRA is not doing well. I've invested in an IRA." Oh, what did you invest it in? "In an IRA." The IRA is just the basket. It's just the account. It's just the holder of your alcohol...
ALISON SOUTHWICK:
Right...
DAYANA YOCHIM:
...and your investments.
ALISON SOUTHWICK:
All right. Let's move on from that. So a 401(k) isn't an IRA, though, right?
ROBERT BROKAMP:
It is not. A 401(k) has to be sponsored by an employer. It can only be offered through your employer. It might also be called a 403(b) or TSP. Like an IRA, they have certain tax advantages, but you can only participate if you're working in that job.
ALISON SOUTHWICK:
So then if you have a 401(k), Dayana, do I also need separate IRAs, as well? Or is a 401(k) going to get me to retirement?
DAYANA YOCHIM:
You want to get as much of your money working for you as possible, so if you have enough money to contribute to both, great, but you want to do that strategically. So let's say you've got this pile of money...
ALISON SOUTHWICK:
I do. I have a huge pile of money right here.
ROBERT BROKAMP:
Look at that pile of money!
ALISON SOUTHWICK:
I take it with me everywhere I go.
DAYANA YOCHIM:
A good order in which to invest it in these accounts is to start with your 401(k), especially if your company offers some sort of match.
ROBERT BROKAMP:
Right. So it might be if you put in $100 in your 401(k), the company's going to match another $50. So it's basically like a bonus they're throwing in to help you save for retirement.
DAYANA YOCHIM:
Yes, so that's free money. After that, take your investment dollars and go over to an IRA, because an IRA offers a lot of flexibility in terms of investment choices ... especially if the funds that have been chosen to be in your 401(k) are crummy and you don't have a world of funds to choose from in the first place.
ROBERT BROKAMP:
Right. You generally have like five to 20 to choose from and you're stuck with those.
DAYANA YOCHIM:
So then you've maxed out your IRA. Got more money after that? Go back to your 401(k) -- the reason being is you're limited to $5,500 as a maximum contribution limit in an IRA or add another $1,000 to that if you're age 50 or over. But in your 401(k), you can contribute up to $18,000 a year -- $24,000 if you're over age 50. So you can get a lot of your money working for you by using all of the accounts available to you.
ALISON SOUTHWICK:
So then I always hear about Roth IRAs versus traditional IRAs. What is the difference, because I've been told a million times what the difference is and I always forget.
ROBERT BROKAMP:
Right, so these are the tax benefits of the accounts, and they're the crux of why you are even considering these accounts. Uncle Sam is saying, "Listen. I'm going to cut you a break to save for retirement."
You can do it two ways. One is the traditional. When you put the money in you get a tax break, but you pay taxes after you retire. The Roth is the other way around. No tax break today, but when you retire you don't pay any taxes on that money. So it's a question of when you want your tax break.
If you are in a higher tax bracket today, the traditional IRA probably makes sense because you're going to value that deduction you get today. If you're in a lower tax bracket and that deduction today doesn't really mean as much, you're going to value having tax-free income in retirement much more. So for Melissa, I would say that for someone who's young and probably starting out with lower income, the Roth probably makes more sense.
ALISON SOUTHWICK:
And also with a Roth, can't you put stocks in there? Like you don't pay taxes on the appreciation for the assets that are in your Roth, too? Say I was brilliant and I put Amazon or Apple in my Roth IRA 20 years ago -- or however long a Roth IRA has been around -- I would have paid taxes on $10 a share price and now it's up to a bajillion dollars and I wouldn't have to pay taxes on the growth.
ROBERT BROKAMP:
Right, and you bring up a great point in that as the investments grow, in both the traditional and Roth, you're not paying taxes. So if in your IRA you bought Amazon at one price, sold it for a huge profit, you wouldn't pay any capital gains. That's the benefit while you're working. It's when you retire you have to pay the piper with the traditional. Then you've got to pay the tax when the money's out. But the Roth? Never. Never have to pay taxes on that as long as you follow all the rules.
ALISON SOUTHWICK:
And we do. We do recommend following all the rules.
ROBERT BROKAMP:
We're all for following rules.
DAYANA YOCHIM:
We're rule followers here.
ALISON SOUTHWICK:
So one of the last questions that Melissa brought up was whether there are any fees to consider.
DAYANA YOCHIM:
Yes, and that's a great question to ask because you don't want fees eroding your investment returns. So generally 401(k) plans have higher fees -- and that mostly comes down to administrative costs in there -- but the reason you stick with the 401(k), and don't just dump it because of the fees is, as we said earlier, you get the match. This is along with the fact that your contributions lower your taxable income. Also, it's got higher contribution limits than an IRA.
ROBERT BROKAMP:
Right. So it actually costs a good bit of money for a company to run a 401(k). Some employers will say they'll cover all those fees. Some employers say they're going to pass them on to their employees, so they might be embedded into the costs of the funds.
So if the fund is in your 401(k), it might charge you 1.5%. If you bought that fund outside of your 401(k), it might be just 0.5%. So, generally speaking, 401(k)s have higher costs and it's better to be in an IRA instead, again, as long as you first take full advantage of the match.
ALISON SOUTHWICK:
All right. So that kind of covers the basics, I hope, and it's really the basic basics. I mean, we could do a show on just Roth IRAs or just 401(k)s...
ROBERT BROKAMP:
And you would love it. You would absolutely love it.
DAYANA YOCHIM:
I'm getting sleepy thinking about it.
Retirement account mistakes to avoid and misconceptions to ignore
ALISON SOUTHWICK:
I know. Sorry, people. We're trying to give you enough information and not bore you to death. Hopefully we're succeeding. Let's just move on and hope we're doing well.
What we're going to talk about now are some of the biggest mistakes or misconceptions around retirement accounts. So some of the mistakes people make and some of the dumb things they think that are wrong. Maybe it's not dumb -- but the things that are incorrect. Okay? First one. Dayana, why don't you take it away?
DAYANA YOCHIM:
All right. One of the biggest mistakes people make -- one in five people do this -- is cashing out their 401(k) when they leave a job. What happens when you do that is, if you are younger than age 59 1/2, you are going to get hit twice with fees.
The first time is with an early withdrawal penalty, because you took that money out of the account and started using that cash before you were allowed to. The early withdrawal penalty is 10%. On top of that, you're going to pay income taxes on that money. So you just gave a huge slice of your retirement funds away to Uncle Sam because of that.
ROBERT BROKAMP:
Right. It's sort of Uncle Sam saying, "I'm going to give you some tax breaks to save for retirement, and it better be for retirement, because if you don't do it, I'm going to penalize you."
ALISON SOUTHWICK:
And you're like, "Ooh! Payday! Ooh! A ton of money."
DAYANA YOCHIM:
Right, and it's tempting. The thing to do is to immediately roll that money into an IRA and, in fact, you don't have to have your company cut the check to you. They can cut the check to a broker...
ALISON SOUTHWICK:
Right...
DAYANA YOCHIM:
...to Vanguard or Fidelity. Whatever.
ROBERT BROKAMP:
You want to do something called a trustee-to-trustee transfer so that the money goes directly from one place to the other. The check doesn't get into your hot, little hands. If it does, you've got 60 days to get it back into either the old account or the new account, or it's considered a distribution. Taxes, penalties, pain. Pain.
ALISON SOUTHWICK:
Many of us are guilty of leaving money at an old employer's 401(k).
DAYANA YOCHIM:
Yes, and sometimes you can leave it there. They won't force you to take it. But you really should take it.
ROBERT BROKAMP:
Yeah. They may or may not. Here, at The Motley Fool, we cover all the costs of a 401(k) for our participants unless you leave the Fool, and then you have to cover those fees. So you might have a great 401(k) and you want to leave it there, but you want to know if you're paying more to do that.
ALISON SOUTHWICK:
Somehow I rolled over my old 401(k) at my last job -- all except like 25 cents. I don't know how it happened.
ROBERT BROKAMP:
It was probably a distribution. You had a fund, or something, and then it moved but you were due the distribution before the dividend date...
ALISON SOUTHWICK:
And now I've got 25 cents -- every quarter I get this statement for 25 cents, and it's such a pain in the patooty. I just want to deal with that.
DAYANA YOCHIM:
I had that with a brokerage account, too, where I had moved money over to a different one. All that was left was 10 cents. Finally I called them, and they said, "We can send you a check for 10 cents or we can just write it off." I said, "Write it off."
ALISON SOUTHWICK:
Right. Keep the change, sweetheart. You've been great.
ROBERT BROKAMP:
The check would be pretty funny. And then you'd have to report it on your tax return and pay the 10% penalty.
ALISON SOUTHWICK:
I'm probably just going to leave it there forever and probably it will hurt me someday. I don't know. Or maybe it will grow. I'll go back and it will be worth $10,000...
DAYANA YOCHIM:
And that will end up being your best investment ever.
ALISON SOUTHWICK:
We can only hope. All right, Robert. What's your first misconception or mistake?
ROBERT BROKAMP:
There are actually several ways to bypass these penalties or taxes or both, depending on the situation, but you have to keep them straight because what applies to an IRA may not apply to your 401(k) or 403(b).
So a real-life story. From an IRA, you can take out your money for qualified higher education expenses. You still have all the taxes, but you avoid that 10% penalty. That's not true of a 401(k) or a 403(b). I know the story of a woman who thought it was. She took out money from her 403(b) to pay for her kid's college and had to pay that 10% penalty because she got confused. So make sure that you know the rules that are specific to the type of account you have.
ALISON SOUTHWICK:
Dayana? You're up.
DAYANA YOCHIM:
Another blunder that people make is waiting until April 15 to contribute to an IRA for the previous year and it's because you have until April 15 to do this, so all of us just really love to run up against the deadline, or maybe that's just the writers here in the room. But people who wait until then give up basically 15 months of returns that they could have been earning had they put their money to work earlier.
Now, remember: When you contribute to an IRA, you don't have to come up with the entire amount all at once. You can add to that account over the year. So do that. Get started. Start contributing to it so you can start earning money on those returns.
ALISON SOUTHWICK:
Dollar cost average over the 15 months.
DAYANA YOCHIM:
That's right.
ROBERT BROKAMP:
Historically speaking, the stock market is up roughly three out of every four years, so the sooner you can get the money in, generally speaking, the better. If you do contribute to your IRA by April 15 of this year for last year, make sure you indicate that on the check because otherwise they might think it's for this year. So if you're contributing for 2014, write that somewhere on the check.
ALISON SOUTHWICK:
I hope you aren't tired of talking, Robert, because it's your turn to bring up the next one ... the next myth or mistake.
ROBERT BROKAMP:
One misconception is that some people think that they can't contribute to an IRA either because they're already contributing to a 401(k) or they make too much money, and that's generally not true. Anyone who's working can contribute to an IRA regardless of their income. Regardless of how much they put in their 401(k). It just depends on which type of IRA you're going to be eligible for.
There's actually one example in which you can contribute to an IRA even if you're not working, and that is if you are a spouse of someone who is working. So you're a stay-at-home parent. You actually can contribute to an IRA as long as your spouse is working.
ALISON SOUTHWICK:
All right. And we have one final to round it out to five, of course, of our biggest myths and misconceptions around retirement accounts. Robert? You have this one.
ROBERT BROKAMP:
Whenever you sign up for an IRA or a 401(k), you probably are asked to designate a beneficiary (basically who's going to get your account when you pass away).
DAYANA YOCHIM:
It's D-A-Y-A-N-A...
ROBERT BROKAMP:
That's how to spell Dayana's name.
You're not required to designate a beneficiary. But make sure that you do, because if you don't have a designated beneficiary, the account will go to your estate when you pass away, and then it has to be distributed, generally speaking, within five years, so your heirs lose all those tax benefits.
If you name someone specifically, they inherit the IRA and they can let it grow for years and years and years. So make sure you name someone and make sure you update it, because you may have filled it out 10 or 20 years ago and now you no longer like that person or that person may no longer be alive. You should update it at least once every few years.
ALISON SOUTHWICK:
All right, that covers it then. Five common mistakes and also some misconceptions that people have around retirement accounts. Hopefully this sets you on the path, Melissa, to start rockin' it with all your retirement accounts.
This show is edited by Rick Engdahl. Music composed and performed by our own Dayana Yochim. And don't forget to put her down as your beneficiary. Email us at [email protected], rate us on iTunes and Stitcher, and don't forget to recommend us to your friends, especially your friends and family members and loved ones who are really lousy with money. Hopefully we can help them out. Fool on!
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