What is an IRA and 401k?

You have probably heard these terms and been a little too confused to figure out what they mean, and they’re usually said from highbrow people who may look down on you for not knowing. And that’s fine. Money talks can be difficult, but learning should not be stifled. Let’s explore what is an IRA, what is a 401k, the differences, the similarities and as much in between as we can.

This might be a little long, don’t worry about having to come back to reclarify things. Also, feel free to skip to the recap for quick facts about the qualities and differences between 401ks and IRAs.

Anyway, let me take you back to me two years ago and every other kid like me who has been failed by the schooling system and has no idea what these retirement accounts even are.

We stumble into our first “real” job around the age of 22. HR exposits a billion things that you have never heard about, let alone worried about. Health Insurance? Dental insurance? FSA? HSA? 401k? 403B? SEP? 457? Free gym but it’s built like an OSHA hazard?

What do we make of all of this?

Basics of IRAs and 401ks

Basically, 401ks and IRAs are accounts that stash your cash at an advantage to you in one way or another and then you can buy assets like stocks with the advantaged money you stashed in these accounts.

Now, you might be asking yourself “What is the advantage?”

Well there are a few. Typically 401ks are run by your for-profit employers, essentially everyone in the private sector. Banks, consultants, engineering firms, even places like chain restaurants and grocery stores have begun to provide them. If you have one, your employer will set aside pre-tax money for your account, typically every paycheck, and put it into your 401k account which are also typically auto-invested into a specific asset.

If you are unsure that anything I just identified as typical is not already happening for you, go check it right now! You might not be invested into anything and your employer might just be throwing your money into its account and they didn’t set up an investment for you. If that’s the case you must go choose something, otherwise you’re getting at least a -3% on your money each year due to inflation!

Now, it might seem hard for you to select an investment if you are not already auto-enrolled into one. If you are enrolled into something, it is most likely a Target Date Fund, which is a fund managed by someone else that aims to automatically re-balance whatever assets are in it as you age closer to death typical retirement age. Target Date Funds are fine, but we can discuss that later.

Picking an Investment

Now, it might surprise you that my answer for what is typically recommended to invest in is the entire stock market.

If you want to learn more about why that is, please check out JLCollins stock series, whose sole goal was to make investing simple for his daughter that wanted nothing to do with it.

This recommendation typically boils down to one option: VTSAX or it’s ETF counterpart VTI. These two tickers – VTSAX and VTI – are functionally the same thing. They are basically a stock that is an Easter Egg basket that has little pieces of every stock available on the market.

If you searched on WeBull or Robinhood for information you can search VTSAX or VTI. As I said, they are basically the same thing, however VTSAX is a type of mutual fund and can only be sold at day’s end and VTI is basically a stock that can be bought and sold as the day goes by with the market being open. The open times for the market is from 9:30-4 Eastern Standard Time, in case you didn’t know.

Again, these funds invest in the whole stock market. Yes – that’s right – the whole stock market. It does so by buying a little bit of every single existing public company. The main ideas behind this are:

1. The stock market goes up inevitably over time (As long as America exists, so if you don’t think it will in the future then our dollars don’t really matter do they?)
2. The out-performers will hugely outperform the underdogs, but you will never know who’s who without seeing the future. So, you might as well get a little nibble of all of them.
   • This makes some sense. You’ve seen the overachievers in school go on to create amazing things right? While most of the school is average and there are many who fall through the cracks even at a good school. But life still seems to march on upward.
3. Diversity is a strength in investing. When one company falls and dies, another rises to take it’s place. By owning the whole thing you don’t care who fills that place, it will be filled or it won’t matter. If it doesn’t matter, then that market isn’t worth it anymore.
   • This is like sitting in a valley and you have a thousand different rivers bringing you water. If a beaver dams one, then you’ll be fine. As opposed to relying solely on one big river for water.

My 401k/IRA Doesn’t Have VTI/VTSAX

But wait! What if your 401k doesn’t have an investment option for VTI or VTSAX?!

No problem! In fact, mine didn’t either. To add onto that, mine was auto-invested into a Vanguard Target Date Retirement Fund which I actually switched out of!

So, I switched to the available Fidelity S&P 500 Index Fund instead.

So the reason I did this are the following:

1. Total Stock Market Index Funds, especially VTSAX/VTI are heavily weighted (at 80% of weight) to the S&P 500 Index. So, if you have no total market options, like I did, and didn’t want to pay for the Target Date Retirement Fund, like I did, then you should be able to invest into some kind of S&P 500 index fund. And that will solve most of your worries of not being able to buy the whole market.
   • Also, by “paying for target date fund” I mean at an expense ratio that is 8 times as high. We will discuss expense ratio in a moment.
2. The S&P 500 index fund does some cool things, like being the top 500 best performing (i.e. money making) companies in America. And many of them are international as well. And if one falls, there’s always 500 best companies. So another company takes the corpse of that fallen one and kicks it into the volcano of failed free market capitalism.
3. Lastly, the expense ratio of the Vanguard Target Date Retirement fund I was in was a whopping 0.4%! Which is a bit of a joke because that’s not actually too bad. The super low expense ratios are a big reason why Vanguard is a company many others like to tout. However, the Fidelity fund for me was a 0.05% expense ratio! I know Fidelity doesn’t have as good as a reputation as Vanguard, but I’m going to gamble on the significantly lower expenses for now, for a product more in line with my goals.

And a note on expense ratios, from what I can tell, you will never really see a true bill from this. It just kind of automatically gets taken out from the underlying assets as they perform over their lifetime. So you might not even notice it, which sucks. But keep an eye out for it if you are ever given a handbook from the HR Department.

Circle Back to Pre-Tax Benefits

Now let’s quickly circle back to something I said earlier but didn’t dive into. Your 401k should be taking money out of you paycheck pre-tax and throwing it into the account balance. This will result in a tax-deduction at the end of the year when you file your taxes. How this works is that it makes your taxable income lower so it makes you end up having to owe less taxes to the government.

The thing that bothers me and might bother you about this is that by taking your money our of your paycheck pre-tax and throwing it into the 401k it becomes “trapped” in there until regular retirement age. For someone like me, and probably someone like you who has student loans – you might be wondering why would I give up any of my hard earned money when I need these loans gone?!

Well, quite frankly, it’s because you should take as many tax efficiencies as possible. And that isn’t about me not wanting to give the cruelly inefficient government more of my money. It’s about making your money, yes, YOUR money work as efficiently as the law allows it. Savings on taxes through and through is just simply a whole lot better for your money as opposed to using it after it has been bullied by taxes. You can always analyze this yourself, but that’s complicated and not the best rule of thumb.

And yes, that money is kind of “trapped” but not really. So, simply relinquish the money for the time being and live on as little after tax money as you can since your wallet will thank you. There are ways and shenanigans to get that money out if you want/have to so it isn’t trapped. But for the forseeable future just simply do not worry about it and let it go.

How Much Should Go Into a 401k or IRA? (And Matching)

So, you might be wondering, “How much am I letting go?” Well, it’s usually about 6% of your gross paycheck your employer will automatically take out of your paycheck and throw it into the 401k. It is very common to get an employer match. This match is typically a half of a percent or one percent of the total dollars you put in. Basically at a 6% pre-tax investment by you, you will receive a 3% investment from your employer.

That is 100% free money. YOU ALWAYS TAKE THE MATCH.

Do you read me?

ALWAYS. TAKE. THE MATCH.

You can always ask to have more pre-tax money taken out as time goes on if you want to, but you always take the match at minimum. If you want to maximize your ability to put money in, then the limits for 2022 is $20,500. That means you can lower your taxable income by that much. But only if you can handle it.

Vesting – A Secret Evil

The last thing about 401ks and the most important when it comes to the match that I never hear anyone in the Financial Independence space talk about is: Vesting!!!

My opinion on vesting is not positive in the slightest. I find it a thin veil of trying to keep you from doing the profitable thing for you and jump between businesses for bigger and bigger paychecks on a more regular basis. The thin veil is that vesting is meant to appear as a way that you have gained a bunch of free money.

So, how vesting works is essentially this: you work for an employer for a certain number of years and suddenly that extra money we mentioned earlier that was put in, that employer match, becomes more and more yours as the years go by.

Usually too many years.

We shall use my last two jobs with their vesting schedule as an example.

It’s very confusing to hear at first, but that employer contribution that is put into your account is not really yours until you work for the employer for a certain number of years. It’s matched, yes, it’s there on paper, yes – but it is NOT yours without spending enough years in service of an employer. And that is vesting as easily as it can be described.

For my last two employers, for the first two years of work you will get 0% of the money they put into your account to match your 401k contributions. That’s right! I did my match like everyone said to, and because I left an environment I was not satisfied with, I realized I got a grand total of zero dollars in employer contributions to my 401k!

So, by using me as an example, it didn’t matter how much I invested into the my 401k because I was going to leave. No one ever seems to mention this vesting issue, including my first employer literally not telling me this was a thing. Yes it was there on paper, and yes, of course I should have known better. I thought all 2% of that money was mine. But none of it was meant to be.

So, let’s continue down the vesting schedule. If I worked for three (3) years, I get 20% of my employer contributions. Which isn’t bad for extra money. But it seems a little silly in my opinion.

And I do have some math to support it.

Math Behind the Evil of Vesting

If I kept contributing 6% of my first ever salary, which was about $138.46 a paycheck, in three years, all of my money taken from my paycheck (without a raise) would be: $10,799.99.

That’s not even a full year of maximum contributions now in the year 2022. Let alone three years from now with inflation in 2025.

Now, how much has my employer contributed to my retirement at a rate of 3%?

$5,399.94

But wait, that’s not all your money yet!

At three years of working for one employer you only own:

$1,079.98!

What’s the percentage of that money versus my stash?

Well that’ll be about 10%.

After three years of servitude only to get 10% of the amount of money that you cannot touch without special gloves.

And wait, you might be saying, that’s 10% return on investment that ain’t so bad.

Well, after three years of working that’s, only 3% a year. That, may keep up with inflation. It’s not really doing too much.

If you decided to put away enough to cover half of the yearly limit of $20,500 for three years you would have $30,750 of your direct money.

How puny does $1k look to $30k?

Well you can see it right here, $1k is 1/30 the amount of $30.

If you actually maxed out your 401k each year, which is an incredible feat, that would be a SIXTIETH of your $60,000-ish dollars saved.

And remember, that vesting is often capped at 3% for employer contributions, so it doesn’t matter if you are putting more money away pre-tax, your employer will not provide any more contribution.

So, is that vesting even worth your time? You can probably tell my answer.

Which is why I think it’s disappointing. I truly believe it is a thin veil of trying to make you to stay at a job longer. Because we all know that you get more money the more mercenary you are. If you didn’t have the time to look under the hood, you might believe your 401k suffers from being more mercernary about your career. BUT IT MATHEMATICALLY DOES NOT MATTER.

So there you have it! What a 401k is for the most part, how it works, for the most part, and how to use it as wisely as possible with the best information I have. For the most part. And that I hate vesting. For the whole part.

So, What’s an IRA?

Now, you may have noticed I did not talk about an IRA at all above.

Unlike the fact that I have personal experience with 401ks, I haven’t opened an IRA yet, but I plan to with Vanguard. An IRA acts very, very similarly to the typical 401k described above. With a few important and major differences.

1. It’s yours – hence the name Individual Retirement Account. No employer may be looking over your shoulder at what you’re doing with your money. You typically open it at a bank or financial institution, so feel free to browse around websites to find info about it.
2. You have the freedom and flexibility to choose whatever investment/asset you want that is available at the institution you opened your account at. No employer limitations.
3. The contributions limit are about roughly a quarter of what they are for a 401k. For 2022 the limits are $6,000 for the year.

Now, there are two different types of IRA accounts and there are different shenanigans allowed when opening one. I will make this like you and I are opening one at the age of 22 and we went the average route and got a college-degree required job.

You can either open a Traditional IRA or a Roth IRA. Essentially that means no tax upfront when putting in for Traditional and no tax on the back end when finally withdrawing for Roth.

Traditional IRA Explained

A Traditional IRA is very akin to a 401k. The difference is, from what I can tell as I have not had the ability to open one and intend to open one, is that you must contribute after-tax dollars into the Traditional IRA BUT when it comes to tax time you will show proof that you contributed to the Traditional IRA and it will lower your taxable income (i.e. a tax deduction) just like a 401k would work.

The weird thing to wrap your head around is that it’s not automatically taken out of your paycheck and is technically going in pre-tax but only if your properly account for it at tax time since you get a deduction.

Another weird thing is there are income limits to contributing to a Traditional IRA and being able to get the deduction.

According to the irs.gov article found here: https://www.irs.gov/newsroom/irs-announces-401k-limit-increases-to-20500

It works like the following:

Tax Filing Status	Workplace retirement plan (like a 401k?)	Lower phase out range	Higher phase out range
Single	Yes	$68,000/year salary	$76,000/year salary
Married Joint Filers and the contributor has a workplace retirement plan	Yes	$125,000/ year salary	$129,000/ year salary
Married Joint Filers and the contributor does not have a workplace retirement plan	No	$204,000 / year salary	$214,000/ year salary
Married Individual Filing Separately	Yes	$0/year salary	$10,000/year salary

So from my understanding, if you fall into any of the above categories and have BELOW the lower phase out range, you can fully deduct the maximum contribution of $6,000 if you contribute to a Traditional IRA. If you are ABOVE the higher phase out range, you cannot deduct anything if you contribute $6,000.

The IRS website defines the amount I noted as $/year salary as “income”. I am led to believe that this is straight up gross total income pre-tax for the year. Not anything fancy like adjusted income for other deductions or credits. I am, however, not an accountant nor have I personally done anything like this myself so I do not know for sure.

You should note, however, that if you are single and working and your employer does NOT have a workplace retirement plan like a 401k then it appears that it doesn’t matter your income and that you can deduct all of the money you contribute to a Traditional IRA. I would check with your accountant to confirm this, I have not been able to check with my accountant as of writing this for their opinion.

But let’s use me as an example, single with a workplace retirement plan. My salary was $68,000 a year. That means if I make a dollar more this year I am going to start getting dinged and getting a lower deduction if I contribute to a Traditional IRA. And as soon as I make $76k a year, it doesn’t even matter anymore I get no deduction. So then I would put whatever money I would use for this into its amazing sister account: the Roth IRA.

Roth IRA Explained

A Roth IRA works essentially the same as the Traditional but one huge difference. You put in after-tax dollars, like the money you’d use to pay back your student loans, then it will grow tax free FOREVER.

That’s right, when you snake out that money at age 59.5 then you do not get taxed. Which is wonderful if you are making bank, but to be honest isn’t as nice if you are in a tax bracket with a rate of 0%. But again, that doesn’t matter because you have the security of knowing it will always bee tax-free instead of gambling on a future potential tax hike.

And the other beautiful thing about a Roth IRA is that you can take out your contributions at any time! You can essentially use it as an emergency fund. You can’t pull out the gains with a penalty but say you put that $6,000 in for the year 2022 and you’re out of money. You’re broke. You can’t even sell your kidney. You can still pull out the $6,000 you contributed to help yourself out.

There are also income limits on this which differ from above and the average person is not likely going to hit them as they are much higher but they are as follows:

Tax Filing Status	Lower phase out range	Higher phase out range
Single	$129,000	$144,000
Head of Household	$129,000	$144,000
Married Joint	$204,000	$214,000
Married Separate	$0	$10,000

And a final note on IRAs! That $6,000 contribution is over ALL IRAs. So you can throw, say, $3,000 into a Traditional IRA and then $3,000 into a Roth IRA for the year but that’s the limit. So just know that if you plan on doing both in the same year.

When Can I Withdraw Money? It’s “Trapped”?

And lastly, while I didn’t want to discuss withdrawal strategies too much here, the earliest age you can withdraw money from any of these accounts without a 10% penalty on the withdrawal is 59.5 years of age. So that’s where the idea of it being “trapped” comes from. However yes you can pull out your money whenever you’d like. Just that if you had a $1,000,000 in your accounts and you take it out, because of this penalty you will only get $900,000 if you take it out before age 59.5.

So, it can be annoying to lose 10% of your money to thin air is all. But if there was some dire need for it, you can take it out with that penalty. You should also note that if you take it out of pre-tax accounts like 401ks or Traditional IRAs that it will be “income” and you might be subject to tax on it. But if you remember being a kid and not making too much money then you can essentially decide your tax rate again later in life and get taxed at 0% for your withdrawal if you take in a certain and smaller amount of money. But that’s an advanced discussion for another time.

So that’s basically the quickest run down I can muster on this slightly complex topic.

The FI Community Typical Consensus

The FI community generally likes pre-tax advantages over taxed, especially with shenanigans like Roth Conversion Ladders. But that’s a topic for another time. If you want to know a bit more about why pre-tax can be so advantageous check out this article by the MadFientist here, where he goes over some math and graphs regarding the 401k, Traditional and Roth IRAs and a regular Brokerage Account like you would open on WeBull or Robinhood. He also goes over a Roth Conversion Ladder if you’d really like to know more about it right now.

There are also Roth 401ks, which I don’t know anything about other than they probably act very similar to a Roth IRA in that it uses after-tax dollars and grows tax-free but I genuinely have no idea and it does not apply to the vast majority of people, so maybe another time!

To put it into perspective for myself I plan on opening a Traditional IRA if my income is low enough to get the tax boost, hold onto a 401k as long as possible then rolling it into my Traditional IRA when I boost from my jobs and then having a Roth IRA for comfort.

Quick Recap of Qualities of 401ks & IRAs

401k

• Employer Based
• Pre-Tax (Automatically by Employer Witholding)
• Can have limited options
• Keep eye on Expense Ratios
• Keep eye out for total market or S&P 500 fund to keep things simple
• Max Contribution for 2022 is $20,500
• Employer’s typically provide matches; ALWAYS TAKE THE MATCH AT MINIMUM
• Keep an eye on Vesting Schedules for Employer Contributions
• Can withdraw at Age 59.5 without the 10% penalty

Traditional IRA

• Institution Based (Like a Bank or Financial Investment Firm)
• Pre-Tax (Put in post-tax dollars but do a deduction at Tax Time)
• Much more options, possibly unlimited. Check with whoever you open an account with.
• Still keep an eye on Expense Ratios
• Max Contribution for 2022 is $6,000.
• Money gets taxed upon taking out
• Deduction becomes useless pretty quickly for moderate to high earners
• Can withdraw at Age 59.5 without the 10% penalty

Roth IRA

• Institution Based (Like a Bank or Financial Investment Firm)
• Post-tax FOREVER!
• Much more options, possibly unlimited. Check with whoever you open an account with.
• Still keep an eye on Expense Ratios
• Max Contribution for 2022 is $6,000.
• Money does NOT get taxed upon taking out
• Much higher limits for contributions
• Can take out contributions at any time, gains are another story
• Can withdraw at Age 59.5 without the 10% penalty

Godspeed,

Dennis