The Ultimate Beginner's Guide to 401ks, Trad IRAs and Roth IRAs

If we gave you $10k, would you rather give $2k to the government or you keep all $10k for yourself?

Easy, right? You'd keep the $10k.

Ok, what about this one?

If we gave you $10k, would you rather grow it into $16k or grow it into $20k?

Obviously, you'd choose to grow it into $20k.

That's what we're going to show you how to do. And if you want to skip around, use the table of contents below:

Investment Accounts Made Easy
How a 401k, Trad IRA and Roth IRA Work
Proof: Tax Advantaged Accounts Work
How to Access Your Money Before You're 59.5
Which Accounts to Invest in First

Ready? Let's start at the beginning — how investment accounts work. 


Investment Accounts Made Easy

Have you ever used a checking or a savings account?

Of course you have. And that's great because it means you already understand 90% of how investment accounts work.

To open an investment account, you need to find an investment bank.

We recommend you use Vanguard. Why?

Because Vanguard is the only investment bank that solely exists to serve your needs.

All other investment banks are structured to serve two parties: their customers (you) and their public owners (people who own a portion of the company).

Each of those parties inherently want opposite results from the investment bank.

Customers want the lowest cost, a big part of which comes from paying as close to $0/mo in fees as possible.

And the public owners want the highest profit, a big part of which comes from customers' fees.

At these investment banks, there's no way to help one without hurting the other.

But at Vanguard, you are automatically both a customer and a public owner. It's basically the same thing as a co-op supermarket, you are both the shopper and the owner, but it's an investment bank.

And so, Vanguard is incentivized to offer you the lowest fees on its funds. (That's what you want. :) )

So Vanguard is the investment bank you should choose.

Just like how inside Wells Fargo you open checking or savings accounts, inside Vanguard you open investment accounts.

The investment accounts that concern us today are a Brokerage, Traditional IRA, Roth IRA and 401k.

Once you open one of these accounts you put money in it, just like you would in a savings or checking.

Then after the money is in the account, you use that money to purchase stocks and bonds.

This process looks something like this:

How a Brokerage Account Works

The most basic investment account is called a brokerage.

You open it with an investment bank and you put money in it whenever you want.

You use that money to purchase your allocation of stocks and bonds. And you can take that money out whenever you want.

The key to finding the hidden green within investment accounts is in the tax implications. 

We're going to make understanding these easy. Hang with us.

So, with a brokerage account you are putting money in that has already been taxed. When your employer paid you, the government taxed that money.

And then when you sell the stocks and bonds you own in your brokerage, you are taxed on the gains. 

For example, say you invested $2k. Over time that $2k grew to $3k.

While the stocks and bonds are purchased, you don't pay taxes. But when you sell the $3k of stocks and bonds, you pay taxes on the $1k of growth.

Here's what it looks like: 

See those lines with the taxes?

That's where we're going to focus here.

Because if we can optimize our tax savings, we can increase our future returns with no unexpected risk.

This is made possible with 401k, Roth IRA and Trad IRA accounts. And once you know how they work, you can select the ones that work best for you and start boosting your long term returns without any unexpected risk.

But before we dive into that, let's make sure you understand how taxes work with a brokerage account — Money in has already been taxed. Money out is taxed on the gains.

Great. Onward we go!


How a 401k, Trad IRA and Roth IRA Work

Each of these accounts is known as a tax advantaged account.

All that means is you benefit tax-wise when you use them.

Here's how each of them works.


How a 401k (or 403b, TSP or Solo 401k) Works

A 401k is an investment account made available by your employer.

If you are a public education or nonprofit employee, this will be called a 403b.

If you are a federal government employee, this will be called a TSP or Thrift Savings Plan. 

If you're a freelancer or own a business, you can create a 401k for yourself called a Solo 401k.

Each has a few tiny differences. But for our goal here, these work the same. So we're going to use 401k as our placeholder.

The way a 401k works is this:

Your employer purchases a 401k package with an investment bank.

They then offer you (their employee) the ability to sign up, open a 401k and start putting money in it.

When you decide how much you want to put in, you simply choose a percentage of your gross paycheck.

For example, say you make $2000/paycheck before tax and choose to contribute 40%. 

Your employer will then put $800/paycheck directly into your 401k ($2000 x 40%).

They will also put $1200/paycheck (less taxes) into your normal bank account.

(Now here is where the increased returns with no unexpected risks comes in!)

The money you put into the 401k is tax free. So the $800 you put in is not taxed.

This means you get to keep an extra ~20% than if the money had been taxed and deposited to your bank account as normal.

This is literally $20 of free money for every $100 you make! That is massive!

So with the $800 you deposit in your 401k, you purchase a selection of stocks and bonds. And inside your 401k, you own $800 of that stock and bond allocation. (Just like the brokerage).

Often, purchasing the stocks and bonds is automatically done based on the selection you choose when you start the account.

Then, down the line, when you to take the money out of the 401k, you pay taxes on the entire amount you take out.

Here's what it looks like:


One thing to note is that 401k's offer a limited number of funds (stocks and bonds) for you to purchase because it is an employer sponsored plan. 

Often the small selection of funds have higher fees. So when checking out what stocks and bonds are available look for the ones with the lowest fees.

As of 2017, you can contribute up to $18k per year to a 401k. And you can access your funds without penalty at age 59 1/2.

We're going to cover a few ways to use the money in your 401k before then, but for now we just want you to understand how 401k's work.

So 401k's. Money in is not taxed. Money out is taxed.


Traditional IRA

A Trad IRA is very similar to a 401k. Here's how it works. 

A Trad IRA is an investment account you open with your investment bank.

You use it by depositing your paycheck in your bank account as normal. Then you take a portion of that money and put it into the Trad IRA.

Here's the magic again.

The amount you put into the Trad IRA does not count as taxable income at the end of the year.

For example, say you make $50,000 before tax and contribute $5500 to your Trad IRA during the year. Come tax time, you will only have to pay taxes on $44,500 of your income.

You don't have to pay taxes on that $5500.

This is called a tax deferral. And it will end up saving you about 20% of the amount you put in your Trad IRA.

Again this is literally free money! $20 of every $100 absolutely free.

So once your money is in the Trad IRA, you purchase an allocation of stocks and bonds and let it sit.

Then when you take the money out, you are taxed on it.

You are taxed on both the principle (the amount you put in) and the gains (the amount the principle grew) because none of that money has yet to be taxed.

Here's how it looks:

traditional ira.png

As of 2017, you can contribute up to $5500 per year to a Trad IRA. And you can access the funds penalty free at age 59 1/2.

We're going to learn how to utilize this money sooner. But for now, all you need to know is how it works.

So, Trad IRA. Money in is tax deferred. Money out is taxed.


Roth IRA

In simple terms, the way a Roth IRA works is the opposite of a 401k and Traditional IRA. Here's how it works.

A Roth IRA is an investment account you open with an investment bank.

You use a Roth IRA by depositing your paycheck to your bank account as normal. Then you put a portion of that money into the Roth IRA.

There's no special tax treatment to the money you put in. It was already taxed when you got the paycheck, and it stays that way.

Once the money is inside the Roth IRA, you then select which stocks and bonds to purchase, and you let it sit.

And here's where the tax magic comes in again.

Down the line when you take the money out of the Roth IRA, you are not taxed on the gains.

So for example, say you put $5500 in your Roth IRA throughout the year.

Then in 20 years, that $5500 grows to $20,000. When you take the $20,000 out you are not taxed on the $14,500 of growth. 

Nor are you taxed on the $5500 you put in because you already paid taxes on that from your paycheck.

Here's what it looks like:


Note, if the same thing happened with a Trad IRA or a 401k, you'd be taxed on the $14,500 of growth.

And, you'd also be taxed on the $5500 principle because you never paid taxes on that either.

This tax free growth is a big reason lots of people choose to contribute to their Roth IRA.

Similar to the Trad IRA, as of 2017 you can contribute up to $5500 per year to your Roth IRA. And you can access the funds both with the tax-free gains and penalty free at age 59 1/2.

And yep, we're going to show you how to access these funds before 59 1/2, but for now we just want to make sure you know how it works.

One question we commonly get asked is, can you contribute to both your Roth IRA and Trad IRA in a year?

The answer is, "Yes, but..." only to the sum of $5500. Most of the time, people pick the IRA that works best for them and only contribute to that one.

So Roth IRA. Money in has already been taxed. Money out is not taxed.


Tax Advantaged Account Summary

Each of the tax advantaged accounts has free money waiting for you to claim. But you can only do it right if you understand the intricacies of each investment account type.

Though the biggest thing to know is the tax implications, you also need to know the yearly contribution limit, the age at which you can withdraw the money penalty free and the breadth of funds (stocks and bonds) you can purchase.

Here's all that in one easy to read chart:


You can stay up to date with these contribution limits, penalty free withdrawal ages and tax implications at the beautifully designed (401k, Trad IRA, Roth IRA). ;)


Proof: Tax Advantaged Accounts Work

But do tax advantaged accounts really work?

Best question yet. Let's back test it.


401k & Trad IRA vs Brokerage

Let's assume you make $36k per year. So each month you make $3000 before tax.

If we assume an effective tax rate of 20%, then you take home $2400/mo from your paychecks.

Because you're living your hidden green, you're stashing and investing 40% of every paycheck.

So, if you are contributing to a 401k &Trad IRA account that's $1200/mo. ($3000 x 40%)

And, if you are contributing a brokerage account that's $960/mo. ($2400 x 40%)

At this point, you have the decision, "Do you want to keep the $240/mo or give it away?"

Let's see what happens with and without our tax magic.

Let's say you invested in the S&P 500 tracking index fund from January of 1990 till March of 2009.

(March 2009 is one of the worst times to stop because it was the bottom of the 2009 financial crisis.)

If you did this with a 401k, you'd have $337,000.

If you did this with a brokerage $270,000.

Here's our question again: Would you like to keep an extra $67,000?

Hell f—'in yes.

Let's say we did this from 1990 till June 2017. If we did that the difference would be $1,441,000 to $1,153,000.

That's $288k!

You'd have to be completely nuts to skip out on that kind of free money!


These numbers are simply true North. They aren't perfect for every minute detail. And getting every detail perfect isn't our goal. Our goal is to show how the concept works. And these numbers do that great.


Roth IRAs vs Brokerage

What if you did this same thing with a Roth IRA or a Brokerage?

Income, $3000 before tax. So take home pay is about $2400 after tax. And because you are living your hidden green, you're stashing and investing 40% of every paycheck.

This means you are depositing $960 to your Roth IRA or Brokerage each and every month.

Using both the same time period and S&P 500 tracking index fund as above we find that: 

If you did this with a Roth IRA, you'd have $270,000

If you did this with a Brokerage, assuming a 15% long term capital gains tax, you'd have $262,200.

Remember, we are showing you the worst case scenario here. Even in the worst case scenario, you are gifted $7,800 of free money.

But let's say you did this from Jan 1990 to June 2017.

If you did this with a Roth IRA you'd end up with $1,153,000. If you did this with a brokerage you'd end up with $1,027,000.

That's $126,000! Free flippin' money.

Roth IRA vs Brokerage

Again, take these numbers only as true North. Our goal isn't to find the exact number down to the dollar. It's to prove the concept and then provide all the tools to take advantage of it.

Also, don't compare the 401k & Trad IRA outcomes to the Roth IRA outcomes. We didn't account for taxes when pulling the money out of the 401k & Trad IRA, and so comparing the two isn't just. We'll give you a map for which accounts best suit you soon. 

For now, we want you to want you to see just how much free money is available for you if you use tax advantaged investment accounts — a 401k, Trad IRA and Roth IRA.   


So What Holds Us Back From Investing With Retirement Accounts?

As we mentioned at the start, if we gave you $10k that you could either give $2k to the government or keep all for yourself, you'd choose to keep the $10k.

The same goes for if we gave you $10k that could either grow to $16k or to $20k, you'd choose $20k.

It's an absolute no brainer.

These are the same things that happen when you use 401ks, Trad IRAs and Roth IRAs.

You pocket the extra $2k up front from your 401k's tax free contribution and your Trad IRA's tax deferral. And then because that extra $2k is invested, your money grows more.

Or you invest the $10k in a Roth IRA rather than a brokerage and when you take it out to use it, you don't have to pay taxes on the gains. So you're left with $20k instead than $18.5k.

Using a 401k, Trad IRA and Roth IRA increases your returns with no unexpected risk. 

So what holds us back?


I Need My Money At Anytime

Some people are held back because they may truly need this money at any moment. 

This is troublesome because it means you don't have an emergency fund set up (a stash worth 6 months of spending in a savings account).

This lack of a stash is causing you to not have the flexibility or courage needed to take off and do what you want to do when you want to do it, much less start investing.

So if that's you, you need to start stashing each and every month. 

And if you want a hidden green life, you need to start stashing +50% of every paycheck. (Once you understand how your savings ratio works, you'll see that anything less is pretty much batshit crazy.)

Where can you learn how to do this? In our free 9 lesson course, Boost Your Stash. (This may feel like a silly pitch, but it's not. It's really here to help you.)

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How to Access Your Money Before You're 59 1/2

But I don't want my money locked up till I'm 59 1/2 you rightfully may be thinking.

Neither do we!

A little known fact is when you add your money to a 401k, Trad IRA or Roth IRA, your money is not "locked up" till you're 59 1/2.

Here's 6 ways you can access the funds before you're 59 1/2.

1. You have access to the principle at any time.

For example, if you put $5k in, you can take that $5k out penalty free any time.

Note though, if you do this with a 401k or Trad IRA, you'll have to pay taxes on the amount you pull out because it hasn't yet been taxed.

And also note, stocks and bonds are more volatile than a checking and savings account. This means that you may have less than $5k in the account at certain points, and you should be aware of that.

But beyond that, you shouldn't be investing at all unless you understand how both investment growth and volatility work. Once you understand this, the above won't be an issue.

2. You can use the money for a first time home, for education expenses and for a disability if you ever need.

3. You can move the money through a Roth IRA Conversion Ladder.

This strategy works best for people who plan to have a number of years of low earned income (paychecks) after their high earning years.

These type of years could be spent raising a child, taking a work sabbatical, slowly starting a lifestyle business, etc.

If you think that you might do this at some point, then you should learn how a Roth IRA Conversion Ladder works over at, the legend, The MadFientist's website.

4. You can set up a 72t Distribution.

This method allows you to withdrawal an equal amount of money from your retirement accounts each year.

If you have interest in that, you should also learn how a 72t works in this MadFIentist article.

5. You can take the 10% penalty, which can be super smart.

This strategy is rarely thought about. But the MadFIentist has shown through tests that this strategy is legit for early money independence seekers too.

6. You shouldn't need the money since you're stashing anyways. 

By both having an emergency fund and stashing money every month, you already have access to money if you ever need it.

If you are worried about not having access to your money after learning all this, then you need to build a bigger emergency fund till you feel comfortable enough to start letting your money make you money over 5, 10, 20+ year time periods.


Awesome. So now we know we can utilize the money in our 401k, Trad IRA and Roth IRA before we are 59.5.

That's great because having that access should make using them an absolute no brainer.

The last thing left for you to decide is the order in which you start using them!


Which Accounts to Invest in First

The true answer here is this is 100% up to you. But we'll give you our take for how we'd think through it.


1. Get Your Stash Increasing Month After Month

If we had to think this through, we'd first focus on boosting our stash every single month until we were debt free and had an emergency fund set up in a savings account.


2. Check If Your Employer's 401k Offers A Match

Once we did that, we'd see if our employer offers a match in our 401k plan.

It's not uncommon for an employer to offer a match up to a certain contribution amount.

If we found our employer offered a match, we'd probably wet our pants in excitement.

And then, after getting ourselves back together, we'd contribute to our 401k until we get 100% of the company's match.

For example, if the company says they will match 50% of every contribution up to $3000, then for every $1000 you put in the 401k, the company puts in $500. And they do this till you put in $3000. 

We'd 100% contribute $3000 and collect the entire company's match.


3. Are You Stashing +20% of Every Paycheck?

After the above, we'd check to see how much of each paycheck we are stashing.

If we were stashing less than 20% per paycheck (which you should know is batshit crazy), we'd contribute to our Roth IRA, 401k and then Brokerage, in that order. 

The reason being is that the low savings ratio means we'd have 40+ years of formal work left to reach the time where passive income from our investments would cover our lifestyle cost.

Because of this length time frame where we'd have a relatively high earned income, we'd be better off maxing out our Roth IRA first. (No tax on the gains.)


If we were stashing more than 20% of each paycheck (think 50% if you're being rational), then we'd contribute to our Trad IRA, 401k and Brokerage, in that order. 

The reason here is the high savings ratio means we will likely have our lifestyle cost covered by passive income in a relatively short amount of time (think 20 years or less).

That would open up more options for us to access the 401k and Trad IRA money (Roth IRA Conversion Ladder) without having to pay taxes on the gains.

Here's a workflow to help you walk through which tax advantaged accounts to contribute to first on your own:

which investment account should I use first

Alright! There's your guide for how to use investment accounts to increase your returns with no unexpected added risk.

If you're out of debt and have a stash, then get rolling and start!  Seriously.

And if you need to start boosting your savings each and every month, that's okay too. Sign up for our free course below.

No matter where you are on your money path, use this as a guide to come back to anytime. 

We hope it helps!

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