There tends to be a quite a bit of confusion between all of the different letters, like Roth IRA, and numbers associated with the various retirement accounts. Many people believe that 401(k)s are “better” than 403(b)s. Many also believe that a Roth IRA performs better than a 401(k).
The confusion stems from the simple misunderstanding about what exactly all of these numbers and letters mean – something I’ve commonly heard referred to as the alphabet soup.
The first thing to understand about the 401(k), 403(b), 457, Roth IRA, and Traditional IRA is that they’re all retirement accounts.
The best way to explain this is to simply look at all of these numbers/letters as a big umbrella.
An umbrella typically protects us from rain, but in this instance they’re protecting your assets from taxes.
Without getting into extreme details and the caveats to everything, retirement plans all have similar features:
Tax-deferred growth simply means that you do not get a tax bill for all of the money (interest) that you earn each and every year.
This is different than a normal brokerage or bank accounts that you earn interest in, in which you will get a 1099-INT form at the end of each year and pay taxes on your earnings.
The major benefit of the tax-deferred growth is that you’re allowed to keep more money in your account that’s earning interest every year. So the effect of compound interest is greater in a Tax-Deferred account (401(k), 403(b), Roth IRA, etc) than in a Taxable account (brokerage, CD, money market, savings account, etc).
While there is the benefit of Tax-Deferred growth, the government certainly wouldn’t allow you to have too much of a good thing, so there is a stipulation on when you can begin withdrawing your money.
While there are scenarios where you can get to this money prior to age 59 1/2, it’s wise for most people to assume they can’t touch it. It is in-fact a RETIREMENT account; that’s why you’ve been putting money in there…so keep your hands off!
If you withdrawal the money before or after age 59 1/2, every penny that you withdrawal is 100% taxable. The only account where this rule doesn’t apply is the Roth IRA (assuming you take it out after age 59 1/2).
The 401(k), 403(b), 457, and Traditional IRA are all funded with PRE-TAX dollars – which simply means you’ve yet to be taxed on all of the money you’ve put into those accounts.
With that understanding, it’s important for you to realize that you WILL pay taxes on your contributions and earnings upon withdrawal (you will only pay taxes on the amount you withdrawal in that given year, not the entire account balance).
Hopefully with my explanation above you now understand that a 401(k), 403(b), 457, Roth IRA, and Traditional IRA are simply retirement accounts.
So the notion that your Roth IRA PERFORMS better than my 401(k) is plain false.
The performance of your retirement account is based on what you own inside of your UMBRELLA.
So, if my 401(k) and your Roth IRA were invested in exactly the same mutual fund, then their performance would be precisely the same.
Sure, you have more investment options in a Roth IRA, but that doesn’t guarantee it will perform better.
Let’s look at some quick facts about each of these umbrellas in hopes that you can learn more about each of the primary retirement accounts:
Picture by digitalart.
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