Retirement Accounts: 401(k), Roth IRA & How Contributions Work

Overview

Retirement accounts are specialized financial tools that allow money to grow with significant tax advantages. This chapter explains the mechanics of 401(k) plans, Roth IRAs, Traditional IRAs, employer matching, contribution limits, tax treatment, withdrawal rules, and how funds grow over decades.

The focus is on structure, numbers, and rules — not advice or motivation.

By the end of this chapter, you will understand:

  • How pre-tax vs Roth contributions differ
  • How employer matching works
  • Annual contribution limits and deadlines
  • Income phaseouts
  • Withdrawal rules and penalties
  • Required minimum distributions (RMDs)
  • How tax treatment affects long-term growth
  • How contributions appear on paychecks
  • How compounding behaves inside tax-advantaged accounts

1. The Purpose of Retirement Accounts

Retirement accounts exist to encourage long-term saving through:

  • Tax advantages
  • Protected growth
  • Employer contributions

They are designed specifically for money that will not be accessed until age 59½ or later (with exceptions detailed below).

Retirement accounts fall into two major categories:

  1. Employer-sponsored plans — 401(k), 403(b), 457
  2. Individual plans — IRA, Roth IRA

2. Tax Treatment: Pre-Tax vs Roth

Type Tax on Contributions Tax on Growth Tax on Withdrawals
Traditional / Pre-tax No No Yes
Roth Yes No No

2.1 Traditional (Pre-Tax) Contributions

You do not pay income tax on contributions in the year you contribute.

  • Salary: $50,000
  • Pre-tax contribution: $4,000
  • Taxable income becomes: $46,000

Taxes are paid later, when withdrawing in retirement.

2.2 Roth Contributions

You pay taxes now, but future withdrawals are tax-free.

  • Salary: $50,000
  • Roth contribution: $4,000
  • Taxable income stays $50,000
  • But withdrawals decades later are tax-free.

3. Employer-Sponsored Plans: 401(k)

A 401(k) is the most common retirement plan provided by employers.

  • Contribution limit
  • Employer match
  • Investment choices
  • Tax structure (Traditional, Roth, or both)

3.1 Contribution Limits

For 2025 (example limits—update yearly):

  • Employee contribution limit: $23,000
  • Employer contributions do not count toward this limit
  • Total combined employee + employer limit: $69,000

3.2 Employer Match

Employer match is free money deposited into your account if you contribute.

Example:
Match: 50% of employee contributions up to 6% of salary
Salary: $50,000
Employee contributes 6% = $3,000
Employer contributes 3% = $1,500

Total annual contribution: $4,500

3.3 Vesting

  • Employee contributions: always 100% vested
  • Employer contributions: may vest over 1–6 years

4. 401(k) Investments

  • Target-date funds
  • Index funds (S&P 500, Total Market)
  • Bond funds
  • Money market funds

All growth occurs tax-deferred in Traditional or tax-free in Roth.

Fees vary by plan. Lower fees mechanically produce higher long-term balances.

5. Individual Retirement Accounts (IRA)

IRAs are available to anyone with earned income.

  • Traditional IRA
  • Roth IRA

5.1 Contribution Limits

  • IRA contribution limit: $7,000
  • Age 50+: $8,000

5.2 Income Limits & Phaseouts

  • Single: Roth eligibility phases out from ~$146,000
  • Married filing jointly: ~ $230,000

Traditional IRAs have phaseouts only for tax-deductibility, not contributions.

6. Withdrawals, Penalties & Rules

6.1 Age 59½ Rule

  • Early withdrawals incur a 10% penalty + taxes (exceptions exist).

6.2 Required Minimum Distributions (RMDs)

Traditional accounts require withdrawals starting age 73.
Roth IRAs do not have RMDs.

6.3 Early Withdrawal Exceptions (Penalty-Free)

  • Medical bills >7.5% of income
  • Health insurance after job loss
  • College expenses
  • First-time home purchase (Roth IRA: up to $10,000)
  • Disability
  • Military service exceptions

7. How Contributions Appear on Paychecks

  • Gross pay: $2,000
  • Traditional 401(k): $200
  • Taxable income: $1,800

Net pay drops ≈ $176, not $200.

8. Growth Over Time: How Tax Advantages Compound

8.1 Traditional vs Roth Example

$5,000 annually at 7% for 30 years → ~$472,000

8.2 Tax Drag Example

Avoiding annual taxes dramatically increases final value.

9. Example Scenarios

Example 1: $40,000 salary → ~$50,500 after 10 years

Example 2: Roth IRA → ~$245,000 tax-free

Example 3: $720 immediate tax savings

10. Common Mechanical Mistakes

  • Mixing up Roth vs Traditional
  • Forgetting vesting rules
  • Ignoring penalties
  • Missing IRA deadlines
  • Ignoring fees

Key Takeaways

  • Retirement accounts provide major tax advantages
  • Employer matches are free money
  • Tax-advantaged growth compounds powerfully over decades