The basics: What are IRA’s and 401K’s?

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IRAs and 401Ks are types of accounts we use to save for retirement. A 401K is a retirement account offered through your employer and an IRA is a retirement account you can open up on your own (without being employed).

Unlike a checking account or savings account, the money in a retirement account isn’t just sitting there. Instead, the money in that account is usually being used to invest in the stock market and make even more money.

Now you may be wondering, “why do I need to use an IRA or a 401K to invest in the stock market, can’t I do that on my own?” Yes, but if you did it that way then you would have to pay a large portion of your profits back to government in the form of taxes.

When we invest money in stocks and make money from that investment we must pay “capital gains” taxes on the profit we make. Most people despise paying taxes, so they might be tempted not to invest their money at all.

The government actually wants people to invest and save money for retirement because it wants its citizens to be less dependent on expensive government programs like Social Security and Medicare/Medicaid to fund some of their basic needs. Thus, to encourage and incentivize people to invest money for their own retirement, the government has created different types of retirement accounts (like IRAs and 401Ks) to allow people to invest money for retirement in a way that is taxed at a much lower rate.

There are several different types of retirement accounts but the main ones are IRAs and 401Ks. Most people are given the chance to invest in one of these accounts through their jobs and oftentimes, their job may offer both a Roth IRA and some type of 401K. Many jobs may even offer a company “match” to further encourage its employees to save money in these accounts and invest for retirement.

For example, one’s job may say “we match up to 7% of your salary when you invest into a 401K.” This means that for every dollar you put into a 401K the company will also put a dollar of their money into your 401K up until the 7% mark. Thus, if you make say $80,000 a year and put 7% of your salary into a 401K, which is $5,600, then your job will also put $5,600 into your 401K. At the end of the year instead of just having saved $5,600 to invest for retirement you now have the $5,600 you contributed yourself plus the $5,600 your job contributed for a total of $11,200 to invest in the stock market and keep.

With this in mind, it is vital that you contribute money for retirement and take advantage of your company “match.” Failing to do so is like leaving free money on the table.

My point? 401Ks and IRAs are types of retirement accounts. They allow us to save and invest money for retirement without having to pay high “capital gains” taxes on the profits we make from our investments. Oftentimes, we can open these accounts through our job and the company will even give us extra money in the form of a “match” as an added incentive.

Tell me, are you saving for retirement? Which type of account do you have through your job?