About U.S. Retirement Accounts

After working in the United States, you'll come across some common retirement accounts (retirement account), such as employer-sponsored 401(k)s, personal IRAs, and so on. The main purpose of these accounts is not to make money through investing, but to use income planning to gain tax advantages.

Don't underestimate those tax benefits. For example, if your annual income is $100,000 right now, according to the 2022 tax brackets, the tax rate on the portion above $89,076 is 24%. If you put that extra $10,000 into a retirement account, when you retire, assuming your annual income drops to $10,000 a year, the tax rate on that $10,000 would only be 12%, saving you 12% in tax directly. If you have no income in retirement, withdrawing that $10,000 may not require any tax at all, which is equivalent to saving 24% in tax.

And for people who plan to stay in the U.S. long term, retirement spending is also a necessary expense. So if your finances allow it, it makes sense to save ahead of time and save on taxes at the same time. That is why this article introduces some common retirement accounts.

401 (k)

Overview

If you start working, the first retirement account you usually encounter is 401(k). A 401(k) is a retirement benefit plan provided by U.S. companies for employees, and it must be supported and administered by the employer; individuals cannot set it up on their own. Similar plans include 403(b) and 457(b). Some better companies also offer 401(k) match, which means however much you contribute to your 401(k), the company matches that amount too, up to a certain cap. In any case, you should not miss out on a free double.

Below is the 401(k) portion from Vanguard's 2021 research report. You can clearly see that the average is much higher than the median, roughly by a factor of three. This shows that although lower-income people do contribute to 401(k)s, the total amount is not large. More of the contributions come from middle- and higher-income groups.

The money in a 401(k) is not just a savings account; you can invest it. However, the investment options in a 401(k) are somewhat limited, and in general you can only buy mutual funds and some index funds. Which products you can invest in depends on the bank that holds your 401(k) and on your company. Some 401(k) plans allow stock investments; you can search for "brokerage option" to see whether your plan allows it. When choosing specific investments, pay attention to fees. After all, this retirement plan may last for decades, and fees can be quite significant under the effect of compounding. ETFs generally have lower fees, so you may want to consider dollar-cost averaging.

Types

Common 401(k) accounts come in two types: Traditional 401(k) and Roth 401(k), and the difference is mainly when taxes are paid.

  • Traditional 401(k): contribute pre-tax income, investments grow tax-deferred, and withdrawals are taxed later (including investment gains)
  • Roth 401(k): contribute after-tax income, investment growth is tax-free, and withdrawals are tax-free

If your income is relatively high now and you expect a much lower tax rate in retirement, then Traditional 401(k) is better; otherwise, choose Roth 401(k). If you expect investment returns to be relatively high, then Roth 401(k) can be better, which is equivalent to paying less in capital gains tax.

Limitations

Withdrawal restrictions: Since this is a retirement plan, there are certain restrictions on withdrawing the money. If you take it out early before retirement, there will be penalties. Under current rules, withdrawing funds from a Traditional 401(k) before age 59.5 incurs a 10% penalty. After your first contribution has been in the account for five years, withdrawing the principal from a Roth 401(k) is penalty-free, but withdrawing the investment gains still incurs a 10% penalty. When you take money out, the principal and gains are calculated proportionally, and taxes are then applied accordingly. Of course, if you urgently need money, you can get some cash through a hardship withdrawal or a 401(k) loan.

Contribution limits: 401(k) contributions are also limited, and the limit changes every year. The easiest way is to Google 401k limit and the year. You can see it for 2021 and 2022 below. In 2022, it was $20,500, up by $1,000 from 2021. Your annual 401(k) contributions cannot exceed this amount.

Employer restrictions: In addition to the 401(k) rules themselves, employers may also impose certain restrictions on 401(k) matching. Some employers stipulate in the contract that if you have not worked there for five years, the matched portion will be clawed back, and so on. Make sure you read the specific terms carefully.

IRA

Overview

Like the 401(k) above, an IRA (Individual Retirement Arrangement) is also a retirement plan. As the name suggests, an IRA is a personal retirement account, so you do not need employer support; you can open one yourself. However, opening an IRA also has certain limits: you must have earned income, such as wages, gig work, part-time work, or freelancing, to open an IRA account. Note that the amount you contribute to an IRA cannot exceed your earned income. If you only have passive income, such as stock dividends, interest, or rent, you cannot open an IRA.

Traditional IRA vs Roth IRA

IRA, like 401(k), is also a retirement account and can provide tax advantages. IRA also comes in Traditional IRA and Roth IRA, and the difference is mainly when taxes are paid.

  • Traditional IRA: contribute pre-tax income, investments grow tax-deferred, and withdrawals are taxed later (including investment gains)
  • Roth IRA: contribute after-tax income, investment growth is tax-free, and withdrawals are tax-free

If your income is relatively high now and you expect a much lower tax rate in retirement, then Traditional IRA is better; otherwise, choose Roth IRA. If you expect investment returns to be relatively high, then Roth IRA can be better, which is equivalent to paying less in capital gains tax. You can use online tools to determine which account suits you better.

If you plan to return home, Roth IRA is usually the better choice. After five years, withdrawals of the principal (contributions) are not subject to penalty or tax.

Opening an IRA account

Many investment platforms support IRA accounts, such as Charles Schwab, Wealthfront, Fidelity Investments, Vanguard, Betterment, Interactive Brokers, Merrill Edge, and so on. You can choose a platform you're used to using to open an account. The process is similar to opening an investment account; you just need to provide your personal information.

If you already have an account on the investment platform, setting it up is very quick. Otherwise, you may need to provide some documents to verify your identity.

Investing

As mentioned earlier, 401(k)s have certain restrictions on the types of investments you can hold. But the range of products you can invest in through an IRA is much broader—basically similar to a regular brokerage account. However, most IRA accounts on investment platforms only offer limited margin, which lets you trade using unsettled funds, but does not allow you to borrow money to trade. For example, Schwab’s IRA offers this feature
With limited margin in your IRA, you can trade using unsettled funds. No interest fees are charged, because you may not sell short, borrow funds, or carry a debit balance using the limited margin feature.

In addition, you can also open an IRA account with add-on features to get more comprehensive investment services. For example, Fidelity offers three tiers of Roth IRA accounts with targeted investment advice, and charges a certain service fee. If you’re just buying broad-market ETFs or low-risk funds, there’s no need to spend the money.

If you plan to focus on investing, I’d recommend a Roth IRA, since not having capital gains tax is pretty great.

Restrictions

IRA withdrawals also have restrictions. Under current rules, if you withdraw money from an IRA before age 59.5, you have to pay a 10% penalty. Of course, if you need cash urgently, you can use a hardship withdrawal to get money. IRA contributions also have certain limits; the 2022 contribution limit is $6,000. A person can open multiple Traditional IRAs and Roth IRAs, and the limit applies to the total across all Traditional IRAs and Roth IRAs combined. In addition, Traditional IRA contributions are not subject to income limits, but the tax deduction does depend on income. For example, if you file as single, once your income is above $78,000, contributions to a Traditional IRA are no longer tax-deductible. Between $68,000 and $78,000, only part of the contribution is deductible.Roth IRA contributions are subject to income limits. If your income is above $144,000, you can no longer contribute to a Roth IRA. Between $129,000 and $144,000, the contribution amount is less than $6,000.

Rollover from 401(k) to IRA

Because investment options in a 401(k) are relatively limited, many people choose to rollover their money from a 401(k) into an IRA. Also, if you change jobs, you can consider moving your old company’s 401(k) into an IRA. Another reason is that some 401(k)s have relatively high management fees, and moving to an IRA can significantly reduce those costs. The general steps for rolling over a 401(k) to an IRA are as follows:

  • Choose an investment platform you like
  • Contact your 401 (k) administrator and your investment platform to learn about the rollover IRA application
  • Complete the forms required by the 401 (k) administrator; the investment products sold in the 401(k) will be automatically transferred to the new IRA account (direct mode)
  • If your money does not go into the new account properly, you need to manually deposit the check you receive into the new IRA account. If the deposit is not completed within 60 days, there will be a penalty

Note that if you roll over from a Traditional 401(k) to a traditional IRA, there is no tax issue. But if you roll over to a Roth IRA, you will need to pay the taxes due.

However, once you move money out of the 401(k), you can no longer use the special 401(k) loan feature (IRAs cannot be used for loans). And if your 401(k) includes stock from a previous employer, things become even more complicated. You can search for the NUA strategy to reduce this part of the cost; I won’t go into that here.

What to do with your 401(k) after returning to China

For people who plan to return to China in the future, is it still necessary to contribute to retirement accounts like 401(k)s and IRAs? First, if your company offers a 401(k) match, you should absolutely max out the match portion without overthinking it. After all, the match is a 100% return, while the early withdrawal penalty is only 10%.

If you plan to return to China, you may want to start with a Roth 401(k) or Roth IRA, or roll into one of them, and make your first contribution as early as possible. That way, after 5 years, the principal portion can be withdrawn without penalty. Although investment gains are still subject to the 10% penalty, that is still much less than the penalty on the principal. If you have a lot of money in a Traditional 401(k), then considering the tax issue, you can first roll it into a Traditional IRA, then convert it to a Roth IRA in batches year by year, and then once each batch has aged 5 years, withdraw it year by year according to your tax rate.

If you do not plan to return to the US again in the future, it is recommended that you roll your old company’s 401(k) into an IRA before returning to China, so that your investments have a bit more flexibility. To reduce penalties and taxes on withdrawals, you may want to hold long-term investments until retirement age. If you might come back later, you can also consider keeping the 401(k) account, since it offers some flexibility through 401(k) loans.

Once again, a reminder: if you want to open a new IRA account or do a rollover, it is best to do it while you are still in the US, because it will be much more convenient. Otherwise, after you return, if identity or address verification is needed, it can become very troublesome. For the IRA account’s billing address, you can use a friend’s place and choose paperless delivery. Each year there may be tax forms and similar mail that someone needs to help receive.

Summary

The core idea behind the series of articles below is to put money into retirement accounts, save taxes in the current year, and then withdraw the money later after retirement when your income is lower, so the tax rate is lower too. And these accounts can be used for investing as well, so the money is not sitting idle.