In the past, I’ve discussed tax-advantaged retirement accounts in great detail, covering both Roth and traditional variations of 401(k) plans and Individual Retirement Accounts (IRA). However, I’ll be the first to admit that retirement accounts are far from simple. So, in this week’s article, I’ll be discussing (and debunking) three common misconceptions about tax-advantaged accounts.
The first misconception I’ll be exploring is the idea that when you contribute to tax-advantaged accounts, namely a Roth IRA, you are “locking up” your money. The assumption is that you won’t be able to withdraw money once you deposit it into a Roth IRA. This can be very limiting, and even harmful, but is a very common thought. In fact, I thought this to be true until just a few weeks before I opened my own Roth IRA. This can be especially harmful because many may hesitate to contribute to their retirement accounts thinking they're “locking” their money up.
This isn’t true; you can freely withdraw contributions from your Roth IRA, only profits are restricted (and in some cases, you can even withdraw profits for a few select uses). This is because you don't receive any specialized tax treatment on your contributions, they are, after all, post-tax dollars. This is unlike a traditional IRA, in which you can contribute pre-tax dollars and deduct your contributions from your tax bill.
So, if you deposit $6,000 into a Roth IRA, and you suddenly need exactly $6,000 for some reason, you can withdraw that entire amount, as long as you don’t touch any profits.
In the same vein, another misconception is saving for retirement simply entails adding money to an IRA or a 401(k) account. This is NOT true and can be very, very harmful. Once you have contributed money to your retirement account, you must allocate your money into certain investments, meaning you need to select a few assets you want to invest in and set your account to purchase those.
Your retirement accounts will not just magically find assets for you to invest in; when you first open your account, you should select a few investments, with the help of a financial advisor, and set your account to automatically invest your money into those.
Another common misconception is that the money you contribute is tax-free. In some way or the other, you pay taxes when it comes to retirement accounts, although you also receive some specialized tax treatment (hence the tax-advantaged tag). In traditional variants of IRAs and 401(k) plans, you pay taxes on your profits when you choose to withdraw in retirement, but can deduct contributions from your tax bill, and for Roth variants, you pay taxes on your contributions, but none on your profits. So, while you do receive an immense tax advantage, you do have to pay some tax, in some form.
It's also important to note that tax-advantaged accounts do have a contribution restriction. When it comes to IRAs, you can contribute up to $6,000 every year. This increases to $19,500 per year for 401(k) plans and applies to both Roth and traditional variants.
I hope this article made tax-advantaged retirement accounts a bit clearer and less intimidating. If you want to read about why retirement accounts are so beneficial, check out this article, and this article if you’re interested in seeing why contributing to retirement accounts can be beneficial early on. Thanks for reading, I hope this was helpful, and I’ll see you next week!