Small Business Realities: What's the Difference Between a 401k and an IRA?

This is one of those questions that pops up routinely. The answer is most important for those of you who own your own business, but it crops up for those who work in small companies, too. So what is the difference between a 401k and an IRA? Well, it comes down to a matter of trust—trust accounts, to be exact.

IRA's are really cheap and flexible

An IRA or "Individual Retirement Arrangement" is just what it sounds like. The account is fully owned and controlled by you, the person who hopes to retire one day. The IRS Tax Code says that, as long as you follow their rules with your "arrangement," they won't ask you to pay income or capital taxes on the money you put in your account until you start taking it out (for more about tax deferral and why it's so great, check "Making Sense of Your Company's Retirement Plan"). The rules here are fairly simple: you need to put the money in a trust for your own benefit. Of course, there are some details, but the banks and brokerage houses have stepped in to cover you there. You can open an IRA account at any average bank or anywhere you would open an investment or stock trading account. And in many cases, it costs nothing to open one. Here is Investopedia's list of no or low-balance IRA account offerings for 2015.

Because the IRS doesn't put many limits on what can go into an IRA account, you can invest in all sorts of things with your retirement money. So, when you do go to choose the bank or broker for your account, check their offerings and ask about things like account management fees or trading fees. We often use different brokerage houses for someone who wants to "sit on" three or four standard index funds as opposed to someone who will be doing more trading.

Use the IRA for you business

Believe it or not, your business can open IRA accounts for your employees instead of a 401k plan. Called a SIMPLE (Savings Incentive Match Plan for Employees), these accounts let you, the employer, contribute money to your employee's IRA accounts without the hassle of a 401k. Cheap, easy and available to any business with less than 100 employees (and no other retirement plan), the SIMPLE only requires you to choose a fixed amount to contribute to your employee's plans—either 2% of her salary each year or a "match" of what she contributes between 1% and 3% of her salary.

The IRA compromise

There is a catch. If you are an ambitious saver, IRA contribution limits might mean that you can't put as much into your account as you like. For 2015 and 2016, your total contributions to both your IRA and Roth IRA can't be more than $5,500 for the year ($6,500 if you are over 55). BUT, if you are contributing to an IRA through your employer's SIMPLE plan, that limit goes up to $12,500 (or $15,500 if you're over 55) per year for 2015 and 2016—and that doesn't include your employer's contribution.

The Great 401k

There are a lot of smaller companies out there that would probably do better with a SIMPLE, but the fact is that 401k's, a type of qualified profit-sharing plan, dominate the U.S. workplace. And there are some good reasons for that. Like the IRA, the 401k is a form of trust account that follows rules laid out in the IRS code  in exchange for tax deferrals.

In this case, though, the rules are more complex and the employer retains a lot more control over what's offered in the plan. And that means some serious compromises for both the employer and the employee.

Employees can only invest their 401k money in what's offered in their employer's plan. If your employer has done a great job sourcing a plan, that should be fine for most people. Historically, though, we've seen a lot of 401k plans that offer expensive and/or limited investments and include high management fees. That leaves employees with a less effective account that can add up to tens of thousands of missing dollars over the course of a career.

Employers also often struggle with their 401k plans. As the employer, you have a fiduciary duty to ensure that the plan is fair and well-managed for your employees. And you have a more complex set of filing requirements so that the government can make sure you are taking that duty seriously. For this reason, it has often been difficult for smaller companies to get a good, reasonably priced 401k plan. Keep in mind that the fees will generally include someone to manage the investments and someone to manage the plan to keep you out of trouble.

Why We Love 401k's

Despite the complexity of 401k's, they remain a favorite even amongst smaller companies. Some of this is just down to the enthusiastic efforts of brokerage houses to sell these plans. But there is a real advantage to the 401k, as well. While the SIMPLE limits employees' contributions to $12,500 ($15,500 if she is over 55), employees can contribute a lot more to a 401k account—up to $18,000 per year for 2015 and 2016 ($24,000 if she is over 55). That extra can mean a lot to the right employee.

The Conclusion

So, which sort of plan works better? As you might expect, it all comes down to the size of the business and the savings ambitions of the employees. If you are an employer, it pays to look at your options. If you go with the 401k, be finicky about the brokerage house or investment advisor you choose—choosing the wrong one can cost you and your employees a lot. And if you are an employee in a small business, don't hesitate to approach your employer if you think there's room for improvement. Most employers don't know any more than you do about retirement plan options and are happy to get better information (especially as it might save her some money, as well!).

If you have more questions about small business retirement plans, send me an email.

High Stakes Learning: why figuring out your investments is so hard

Last week we kicked off the Women & Finance series with a "Stocks & Sushi" stock trading game night in Cambridge. As you might have guessed, the emphasis was on having a good time. Our 15th Floor event room above Kendall Square gave us panoramic views across to Boston, and trays of sushi, cakes and a case of wine meant no one was feeling particularly stressed out about learning anything. But the learning—along with a healthy dose of competition (and a little buttercream frosting)—happened all the same.

Since Thursday, I've had a slew of comments and emails from attendees about how much better they understand their own investments since participating in the game. The game itself is a version of something I used to do with an auditorium full of undergrads when I taught the origins of the modern stock exchange. You can't, in my opinion, really understand how and why stock prices fluctuate (and how bonds work at all!) until you are in the middle of the psychological cauldron that is a marketplace. When the dice send the market into a meteoric rise, you can actually feel the tempting pull of the next big bet or the cautionary tug of anxiety, even though those make-believe shares of "Doctor & Gamble" in your hand are, literally, not worth the paper they are printed on.

So why, if this all quickly becomes clear in the game, do the real investments in our 401k account remain so murky to us? I think the answer has something to do with the stakes of the game.

I once had a conversation with a client about why her teenage daughter seems to magically understand all the bizarre features on her smart phone while my client still struggles with turning the camera on and off. "Think about when you use the phone," I said, "you've got a grocery bag in one hand, your half-drunk coffee in the other and you realize you have to make a quick work call in the two minutes before a meeting starts." On the other hand, her teen is using her phone while waiting in the car with a bag of chips and her feet on the dash. While my adult client has precisely three seconds to get the phone to do exactly what she needs before everything starts to come unglued, her teen can play with every button, slide and touch without worrying about it. She's literally just playing around (and she's not paying for that phone). We don't say this often, but the teenager with the smart phone is in a much better state for learning.

If you really want to learn something, it has to be ok to try stuff out, to take risks, to push random buttons and see what happens. But unless someone's already covering retirement for you (wouldn't that be lovely), you aren't going to feel that relaxed about your actual investments. Which means we need to find ways to make learning about finances a more playful experience. It can be events like stock trading night (no one cried or lost their homes when American Textiles went bankrupt following an embezzlement scandal). Or we could be using all of those apps and game software to make the foundations of our financial system accessible to anyone who wants to understand them. And sometimes the answer is just in the way we present investment choices to people. Frankly, those of us in the financial industry—from actual financial advisors to the agents and brokers handling most of the country's retirement plans—have kept the tension high and the chance for learning pretty low. We are going to need to do better.

In the meantime, we will get going on another Stocks & Sushi night. I'm feeling like "Donut Barn" has some real earnings potential.

Think Like An Investor

I came up with this post after meeting with a favorite client today. She's a charming and intelligent woman with a good career and a 401k who, until recently, had never thought of herself as an investor. Investments were complicated things designed for wealthy people. And then she realized that she wanted to buy a home. Part of our problem with the term "investor" is that too many of us picture this when we hear it:

There is some kind of vague understanding out there that "real" investors have special access to a supply of financial jargon, legal tricks and overpriced cuff links that somehow make sense of those relentless scrolling stock prices on CNN. And let's face it, throwing in tax references (tax-deferred, capital gains, tax efficiency) isn't helping. It's enough to make any reasonable person throw her hands up. And it's no surprise that so many of us, even when we actually have investments, don't think of ourselves as investors.

Watching the determination with which my client approached her goal of homeownership really brought home what we are doing wrong when it comes to investing. Buying a home is a form of investing, but where talk of 401k's and index funds makes people feel overwhelmed and anxious, talk of mortgage calculations and down payments has a completely different effect. People who feel empowered as they approach home ownership. And that's important. Because while I am the first to point out that homeownership isn't a good investment for everyone, the real estate industry has done something right by making clear that every buyer should feel like she belongs at that proverbial homeownership table just as much as any coiffed businessman in navy suit.

Since the great home building boom of the 1950's, Americans have understood that our economy depends on the willingness of  "average" middle-class people to buy homes. But we seem to have forgotten that our economy depends on those same people to hold up everything else, as well,—grocery chains, cars, professional services, restaurants, charities, and yes, stock markets. Because no matter how wealthy our wealthy class gets, they are never going to make, hold or spend enough money to sustain a modern economy (feel free to ask me why "trickle down theory" was a clever illusion).

All of this leaves us with a dilemma. Most of us believe that we are cut out to be investors in housing, even if we aren't quite ready, yet. And we believe (even if we have temporarily forgotten) that we, in fact, are the U.S. economy when we work and when we spend. But we don't seem to realize that we are also the "public" behind publicly traded corporations and the only reason that stock markets are worth tracking. The hard truth is that we depend on these markets to ensure that we have funds to live on after 65 and that we have the money to buy homes (or to help our children buy them). So how do we convince one another to demand a little more clarity around the retirement plans and investment accounts on which we depend? How do we claim our places at this other table?

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:

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.

Ahem.

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.