In previous weeks, we considered how to determine the percentage of your income you should be saving for retirement and how to jump-start your savings. In between those two topics, we also considered how to choose your retirement age and why the age you retire matters. Today, we discuss the different retirement accounts that are available and some tips to help you select a plan that works best for you.
A retirement account is an account where you can invest and grow your retirement savings. In the first quarter of 2020, we looked at the different investment options available for an investor. These retirement accounts help to invest your money in some of these options so you can grow it in preparation for retirement. However, these retirement accounts have different features, which will determine their suitability for different individuals.
Below are the popular retirement accounts that you can create:
The 401(k) is the most popular retirement account. It is an employer-sponsored account, also known as a defined contribution plan. With a 401(k), an employee contributes a portion of his pre-tax income for retirement. Contribution to a 401(k) is limited to $19,500 for employees under 50 years of age, while it is limited to $26,000 for employees above 50.
Contributions to a 401(k) are also tax-deferred; this means you will only pay taxes when you make withdrawals on that account. Withdrawing from a 401(k) before the age of 59 ½ will attract a penalty. On the other hand, owners of 401(k) must begin to make withdrawals (required minimum withdrawals) from age 70 ½
Some 401(k) plans allow the owners to take 401(k) loans, which means they can borrow money based on the amount they have in their 401(k) accounts.
An essential feature of a 401(k) is employer matching. Some employers will contribute an amount (a percentage of the employee’s contribution) that matches the employee’s contribution up to a limit. The limit ranges from about 3% to 6% of the employee’s pre-tax income. Let’s take Pat as an example. Suppose Pat earns $50,000 every year, and his employer matches 50% of his contributions. Let’s also assume the employer matches 50% of his contributions up to 5% of total income. This means that if Pat contributes $4000 every year, the employer will contribute $2000 (50% of $4000) as long as it is not more than $2500 (5% 0f $50000).
Some employers use what is called ‘vesting schedule,’ which specifies a minimum number of years an employee must spend with the employer to access the employer-matched contribution.
A solo 401(k) is a retirement account for small business owners who do not have any employees. A solo 401(k) allows the owner of the account to contribute up to $57,000. An account owner who is 50 years or older can make additional catch-up contributions up to $6,500.
A Roth 401(k) is a type of retirement account that combines features of 401(k) and Roth IRA. With this account, you will contribute a part of your after-tax income to the plan. Contributions to the account are not subject to tax as long as you remain in the plan for up to 5 years. Unlike the 401(k), the limits to contributions are stricter with Roth 401(k). For single filers, phase-out begins when your modified adjusted gross income (MAGI) reaches $122,000. You can no longer contribute if your modified adjusted gross income exceeds $137,000. For joint filing, phase-out begins when MAGI reaches $193,000, and you can longer contribute if MAGI is above $203,000
It focuses on employees who work for state and local government agencies. Like the 401(k), contributions are limited to $19,500 for workers less than 50 and $26,000 for workers above 50. Unlike 401(k), you can withdraw money from this account before 59 ½ without any penalty.
403(b) is a retirement account for people working in tax-exempt and non-profit organizations. A 403(b) allows you to contribute up to $19,500 if you are less than 50 years of age; the limit increases to $26,000 for workers who are 50 years or older. The earnings in a 403(b) account are tax-free until withdrawals (distribution).
IRA (individual retirement account)
All the retirement accounts are employer-sponsored. However, an employee can also decide to open an individual retirement account. An IRA is open for people with earned income (wages, salaries, bonuses, commissions).
Unlike 401(k), the limit to an IRA is $6000 and $7000 for workers 50 years and above. Contributions to an IRA, unlike 401(k), are from after-tax income. However, there will be no tax deduction on the funds until you make withdrawals. IRAs also have a minimum required withdrawal once you are 70 ½.
Roth IRA is a special form of IRA. The contribution limit is the same as the traditional IRA. The contribution is also from after-tax income. However, unlike traditional IRAs, you will not pay tax on withdrawals, and there is no minimum required withdrawal at 70 ½
You can also make withdrawals from the account before retirement, provided it is after at least five years from the time you made the first contribution.
SEP IRA is short for Simplified Employee Pension IRA. This retirement account is for business owners with employees and other self-employed individuals. It allows you to contribute 25% of taxable income or $57,000, whichever is less.
The contribution to the SEP IRA is from pre-tax income. Withdrawals from the account are, however, subject to tax. There is a minimum required withdrawal once you are 70 ½ and there is a penalty for early withdrawals (before 59 ½)
A self-directed IRA is similar to a traditional IRA. The difference is in the investment options. While a traditional IRA will invest in stocks, bonds, etc., a self-directed IRA invests in precious metals, real estate, cryptocurrencies, commodities, and limited partnerships. You can open a traditional self-directed IRA or a Roth self-directed IRA.
Simple IRA stands for Savings Incentive Match Plan for Employees IRA. It is for businesses that have a hundred or fewer employees. For an employee to qualify, he or she must receive at least $5,000 from the company in the last two years and be expected to receive at least $5,000 in the current year. The contribution limit is $13,500, while employees who are 50 years or older have an additional catch-up contribution of $3,000. Employers also match the employee’s contributions.
Contributions to the account are from pre-tax income. Withdrawals are subject to tax, and early withdrawals attract a penalty. Also, you cannot borrow money from a Simple IRA, unlike some 401(k).
You can find some other accounts that are not so popular on the IRS website.
Choosing a retirement account(s)
You will need to consider some essential factors before deciding on a suitable retirement account. Some of them include:
Employee vs. Self Employed
If you are an employee, you have more options compared to the self-employed. A self-employed individual cannot access 401(k), traditional IRA, or Roth IRA. The self-employed can only access accounts like the Solo 401(k) and the SEP IRA. Therefore, the first important consideration is to understand the accounts for which you qualify.
If, as an employee, your employer matches your contribution to the 401(k) (or whatever employee retirement account you have), then you have to max out your contribution to the 401(k). In the example we considered, Pat was able to get $2,000 from his employer. However, from our calculations, the maximum contribution the employer can make is $2,500. Why leave that $500 on the table? Instead of contributing $4,000, Pat can increase his contribution to $5,000 to take full advantage of the employer’s contribution.
In the absence of employer matching
In the absence of employer matching, you may need to choose between a 401(k) and an IRA. This choice assumes that you cannot fund both retirement accounts at the same time. In that case, you will need to consider some factors to decide if you should go with a 401(k) or an IRA.
- Fees: Will you incur higher fees with the 401(k) or the IRA? It is essential to compare the fees associated with both types of retirement accounts to determine which is more profitable.
- Withdrawals: You should also consider the withdrawal policies. 401(k) will allow you to make withdrawals (subject to a penalty before age 59 ½). However, you would want to know if the 401(k) allows the loan option – where you can borrow money from your account. With IRA, withdrawals do not incur any penalty. The accessibility of funds is another important factor you should consider.
- Investment options: You should consider where they are investing your retirement funds. If an IRA gives the ability to invest in a wider variety of funds compared to a 401(k), you need to consider that fact before deciding.
- Tax: How vital is tax-deduction to you? With a 401(k), you will get a tax deduction since you are contributing from pre-tax income. With IRAs, you will contribute from after-tax income and get no tax deduction. However, with Roth IRA, you will not pay tax at withdrawals (contra traditional IRA and 401(k)). You also need to consider how vital tax deduction and tax-free withdrawals are to you.
This is especially crucial if you plan to leave the money in your retirement account for other beneficiaries. In that case, Roth IRA that allows tax-free withdrawals with no minimum required withdrawal may be a better consideration than a 401(k) or traditional IRA.
- Professional Management: If you choose an IRA, you may need to pay for professional management if you do not have the time or skills to manage your funds. If a 401(k) provides professional management for free, that is an important factor you need to consider.
No employer matching but you can fund two accounts
If there is employer matching and you can fund two accounts, ensure you max out your 401(k) before funding an IRA.
However, if there is no employer matching, you will need to use the factors in the previous section to determine which of the accounts will be the primary and the one that will be the secondary. You will also need to choose between the traditional and Roth IRA. Alternatively, you may decide only to use IRAs and set up two types of IRAs.
If you set up both the traditional and Roth IRA, keep in mind that you cannot exceed the $6000-$7000 limit for the two accounts combined. In other words, you cannot contribute $6000 to each account. It’s the total contribution to both accounts that must not exceed $6000.
The catch-up feature is useful for those who have not accumulated enough nest egg for retirement. It applies to those who are 50 years or older. For 401(k), it extends your limit by $6500 ($26000-$19500), while for IRAs, it only extends it by $1000 ($7000-$6000). The difference between an additional $6500 (401(k)) and an additional $1000 (IRA) is another thing you may want to consider.
It’s crucial to understand the available retirement accounts and the essential factors to consider before making a choice. You should give enough thought to this, reviewing your financial plan and retirement goals.