Understanding Retirement Accounts


Of all of the topics that come up in my line of work, this has to be the one that creates the most confusion. We Americans are at the point where we have all heard about 401k's and pensions and probably about IRA's and Roth's. And for the most part, we are relying on these strange creatures to feed and house us in the last years (decades?) of our lives. But precious few of us really understand retirement accounts. This post is meant to give you a bit of a run-down on how retirement plans work with a  quick graphic at the end to get you thinking about the plans that might work for you.

The Magic of Tax Deferral

Let's start with the basics—anytime we call something a "retirement" account, we are actually saying that the account has some special mention in the IRS's regulations that will amount to a temporary tax break. You noticed the word "temporary", right? Except for the Roth, which I'll get to in a minute, retirement plans allow you to put a certain amount of your income into the account instead of paying taxes on it...for now. It's called tax deferral, and you not only get out of paying the taxes the year you earned them, you also don't have to pay any capital gains taxes when you sell investments in that account over the years. That gives you the ability to freely move in and out of investments without the usual tax consequences and lets the income you originally put in keep compounding—assuming those investments you chose are any good.

But you do have to pay taxes eventually. In the case of retirement accounts, this happens when you start taking money out— a process known as taking distributions. What's more, the IRS has something to say about when you will be doing this. In most cases, you will pay a penalty for "early withdrawal" if you take your first distribution before age 55. And you will be required to start taking your money at age 70 1/2, because after all, the IRS won't wait forever.

The Roth IRA (often just called a Roth) is a little different. Like 401k's and regular IRA's, your money can grow free of capital gains taxes over the years in a Roth. But if you open one of these accounts, you put your money in after paying the income taxes. This means you won't get that immediate tax break, but believe it or not, this might actually work out well for you. When you do go to take money out of the Roth account, you don't have to worry about the taxes on the money you first put in the account (you already paid those taxes, after all). This can reduce the strain of taxes in retirement and may even mean paying a lower tax rate on that money, say, if you are in a higher tax bracket in your mature years.

In reality, the most successful savers will use both Roths and whatever other accounts they can. The caps on how much you can contribute to a retirement account often mean layering accounts to the extent you are able.

Defined Benefit vs. Defined Contribution

This is the biggest change in the U.S. retirement system over the past 50 years. Defined benefit plans are exactly that—the plan defines in advance how much you will get in benefits. Most of us just call these pensions, and they were the most common type of retirement income for most of our history. Based on the length of time you've worked at a job and the amount you earned, your HR department will calculate how much you get in your monthly check during retirement. Nowadays, though, you are far more likely to be offered a defined contribution plan. These plans set terms for how much you can contribute and make no promises whatsoever about what you get back later.

This change is a big deal— and not just because people are less likely to contribute to the often-voluntary defined contribution plans. In the case of a pension (defined benefits) someone else is taking the risk that the markets will go down or that the beneficiaries (including you) will live longer than expected. If you have a defined contribution plan, that risk is all on you. This means that you need to do some careful calculating and some educated guessing to come up with a balance of investments that will grow enough to cover your needs and will likely be there when you need them. The change over from defined benefits to defined contributions has made it necessary for Americans to become smart investors.

The Magic of Timing

If you are worried about living for more than a few years after your retirement, you are going to want to focus on your timing when it comes to retirement accounts. I am not referring to when you start putting money away here—the earlier the better, of course. Honestly, though, most successful retirees started saving at the peak of their careers, not the beginning. Get started when you can and work from there.

But you should be strategic about which accounts you put money into first and which accounts you start withdrawing from when.

The timing of adding to accounts is relatively simple for most people. We always start by looking to see if a client's employer will "match" contributions. If so, we maximize that first (getting someone else to fund your retirement is always good). If the client has his or her own business, even if it is a "side" business, we have a lot more to play with and timing will often depend on the needs of the business, which is often itself part of the retirement solution.

Taking out the money is different matter. The trick here is to take advantage of the incentives that employers and the government give you and to recognize the requirements. Social security, for instance, gives you all sorts of incentives to wait until 70, so if you can draw from a 401k account or an IRA instead during your 60's, you probably should. Likewise, an old company pension might give you a much better monthly payment for waiting. But you can only wait so long on IRA's and 401k's—as I mentioned above, the IRS requires that you start taking at least some distributions when you reach 70 1/2. The Roth, always the exception, allows you to keep money in that account as long as you want. Choosing which accounts to draw from and when is a delicate game of knowing your income needs, getting the most you can from the incentives and keeping an eye on the taxes you will pay as your start taking that retirement income.

Which Retirement Accounts Should You Use?

Retirement accounts are only one piece of the puzzle when you are coming up with a plan for enjoying life after 65. But they are one of the most important pieces. Here is a quick graphic showing the most popular types of retirement accounts and which ones you might want to learn more about:

Retirement Plan Choices


Working In "Retirement"


What post could be better for a Friday afternoon that one on all the great things you could do in your "retirement"? Financial planning has built its reputation as an industry by selling people on that semi-mystical period after your "real work" ends. But because so many of our clients are under the age of 50, retirement planning tends to be the least of what I do. It turns out that's just as well. It seems that many of us in the post-Baby-Boomers generations aren't planning a traditional retirement anyway. And that makes sense for a number of reasons.

Back in 1940, shortly after social security was introduced, a man or woman who was retiring at the age of 65 could expect to live on average another 13 years to age 78. By 1990, men who were 65 years old lived, on average, to about 80 years old, but women were looking at almost 20 years worth of retirement—to the age of 85. And the life expectancy numbers have grown bigger since. Even if you can afford to sit around on a golf course in Arizona for a few decades, would you really want to?

But there are some important considerations if you are planning on a working retirement.

How realistic is your work plan?

Keeping part-time work sounds easier than it is. You might assume that your willingness to take less income will make it easier to maintain a consistent income. Too many older workers have found, too late, that starting a new business or maintaining an old one part-time can result in long periods without any earnings—and that might not have been part of your plan. If you will have plenty of money to live on and don't mind whether the income comes in or not, you're in great shape here. Otherwise, you need to think ahead.

Start forming partnerships early. Ideally, you should start talking to people a few years before you plan to cut back on work. If you plan to continue as an employee somewhere, make sure you discuss your future role and everyone's expectations. Moving from a full-time to a part-time position always means that some duties and relationships have to shift. And pay attention to the stability and plans of your employer—do you have a plan B if the company moves, closes or changes its role?

Planning ahead is even more important if you hope to continue on in "retirement" as a consultant or a small business owner. As the end of your current career approaches, you will want to spend more time, rather than less, networking. And if this is a brand new business, remember that new businesses typically take 5 years to return a profit even if things go well.

Use Social Security and retirement accounts in the right order

Even though you will be earning some income in "retirement," you are probably hoping to take at least some of financial pressure off of yourself by drawing on retirement savings. Choosing which retirement savings to take first can make a big difference. Most people figure they'll start with social security. In 9 out of 10 cases, this is the wrong way to go. Here's why:

Full retirement age for social security at this point is age 70.Taking benefits before then will mean that those monthly benefits are discounted for the rest of your life. The longer you live, the more money you have missed out on. But that's not the only loss. What most people forget is that you get even more in social security benefits if you add in the few years of extra work you did in your working "retirement" before age 70. That additional income, even if its small, will also count toward your lifetime benefits. In other words, if you plan to earn more income after you "retire" you can keep adding to your future social security take.

*Note that in telling you to wait to 70 years old, I am contradicting the latest internet pop-up craze in which you take benefits early, invest them until age 70, and then returning the all the original benefits to the Social Security Department so that you can start over. Does it work technically? Sure. Is it likely to work out that way for most people? Nope.


What are your other options? Before you start taking from social security, consider taking from your IRA's or 401k's, etc... You can start withdrawing from standard retirement accounts penalty-free (though not tax-free) at 59 1/2. If you are fortunate enough to have a pension fund from a former (or soon to be former) employer, ask the HR department to help you calculate the amount you will receive monthly under different scenarios. Even if the pension discounts your monthly amount for claiming early, the penalty probably won't be as much as it is for social security.

Or use your savings. Your emergency savings (about 6 months of expenses) is for emergencies. But if you have put aside a pot of savings beyond this amount, it may make sense to draw from this first. If you are past the age of 59 1/2, the big question is likely to be, "what about taxes?" The money you put in your 401k's and IRA's is tax-deferred. The deferral ends when you start to take it out. On the other hand, the money you put in your investment or savings account (and your Roth IRA) was added after you paid income taxes on it. That means your tax bill for these type accounts will be limited to capital gains—which is likely to be a lot lower.

You are always going to pay tax on income at some point—the smart tax payer tries to time those tax bills for period in life when her income tax rate is lower.

Account for the costs of work

Any financial planner will tell you that most people underestimate how much they are actually spending. But here is the pleasant surprise—most people overestimate how much they will spend in retirement. It turns out that a lot of the costs we associate with daily living decrease or go away completely in the later years of our lives. It might be mortgages or loans that get paid off, children who don't need anymore help, or clothing budgets that slowly shrink as work-wear ceases to be a concern. It could be simply that we no longer need to spend so much at dry cleaners, gas stations, and take-out restaurants when our careers are not snagging the best portion of our time.

If you are planning to continue working in "retirement" you need to add back in a few of those costs. And this is especially true if, as a small business owner or a consultant, you have business expenses. Make sure that whatever financial plans you make, you account for the costs of working.

Think daily

This advice applies whether you plan on working in retirement or not. During our hectic work lives, we develop all sorts of fantasies about what an alternative life could look like. And we often set these fantasies in "retirement." But the living in the hut on a Caribbean beach, running a French B&B, and founding that tech start-up are all going to look very different in daily life than they do in your work-induced fantasies. Before you commit to any plan for a new life, find opportunities to test out what that life would feel like if you actually lived it on a daily basis.