IRA, 401(k), 529...What does it all mean?

Something I hear over and over from clients, friends, and family members is confusion over all the different financial accounts out there: IRA, Roth IRA, 401(k), 403(b), HSA, 529, etc…there’s a lot of them! If you read these and you’re ready to tune out - stay with me for a minute. I will be posting a glossary to outline each account and a couple of important facts about each. They all have different names to differentiate between uses - retirement, healthcare, education - and how the IRS applies taxes to the account.

I hear questions like: “Is a 401(k) a good investment?”; “What kind of rate of return does an IRA get?”; “Should I open an IRA at two different banks to diversify?” These are all legitimate questions because most people never learn the basics about what these accounts are and how they are set up.

I was talking to a family member about this recently. She was working to get all of her accounts organized and in the right spot, consolidating old 401(k) accounts, and making a plan for the future. When she had questions about what the different account types were and which was best, I compared it to our cups sitting on the coffee table. We had a glass cup, insulated thermos , and a mug. These are all containers that carry liquid, it’s up to you to decide what liquid goes in it. There is no inherent investment risk when you open any of these accounts, they are simply account names. The risk comes when it’s time to choose your investments - the liquid.

For the example below, remember: Cups = accounts liquids = investments

Let’s use the an IRA in this example. There is no difference between an IRA - “the cup”- at Fidelity, Vanguard, Merrill Lynch or any other bank you go to (other than small administrative fees). However, the fees associated with the investments - “the liquid” - will vary from bank to bank. Regardless of where you open the account all IRAs have the same eligibility rules, tax implications, contribution limit, income limitations, etc. The difference comes when it’s time to put in the “liquid”. When you open the account you will decide what your “asset allocation” will be. This is your investment, where rate of return comes from (how risky or conservative), and where you need to diversify. 

Story time - When I was a financial advisor I met with a prospective client who was concerned about the performance of their Roth IRA, which they opened at their local Credit Union in the spring of 2009 - the bottom of the Great Recession. I met with them in 2014; based on their age and the appropriate amount of risk they should have been taking, it would be fair to assume they could have doubled their money over those 5 years, or at least close to it. Instead, their account had increased by less than $100. The reason…all of their money was in cash. It was basically a savings account. When they opened the account they assumed the account was the investment and left it as is. This small oversight cost them ~$30,000-40,000 in that 5 year window and much more if you look at the compound interest over 30 years.

Now, please do me a favor: review all of your accounts and be sure you are taking the appropriate amount of investment risk within those accounts. Talk to your financial advisor or banker to figure out what is best for you. Don’t assume just because you opened the account that your money is allocated correctly.