As you start planning for retirement, you can quickly start to feel overwhelmed with decisions and options. Part of the issue relates to the large number of retirement accounts that currently exist. Each of these accounts has its advantages and disadvantages, and you may not know which is the best for you or even why you should consider other options.
In some ways, learning about retirement accounts is like learning a new language. However, by going over the basics of each type of account, you can quickly start to get a feel for when you would need to use each, which can make you feel more confident when you start to make decisions for retirement. The different types of accounts have various tax ramifications as well as varying caps on contributions. Some of the key accounts to know include the following:
1. 401(k) Plans
A 401(k) is likely the first type of account to jump into your mind when you consider retirement investing. With this account, you contribute your pre-tax earnings, which then get invested. These investments grow without any taxes due until you retire. Once you start to draw on the funds during your retirement, you will need to pay income tax for the amount taken out of the account. Furthermore, you will face a penalty (up to 10 percent) if you withdraw before reaching legal retirement age.
Many employers match contributions to a 401(k), at least up to a certain percentage. While the employer match may not occur until you have employed with the company for several years, it is basically free money, so you should take advantage of the offer as much as possible.
At the same time, the IRS imposes limits on plan contributions each year, and most plans have fairly limited investment options and may charge substantial administrative fees.
2. Roth 401(k) Plan
A Roth IRA involves contributions from post-tax earnings. Because individuals have already paid taxes on the contributions, they can withdraw from the account during retirement without any sort of tax ramifications.
This plan makes sense for people who may be in a higher tax bracket once they retire or who want to make contributions past the limits of a traditional 401(k). However, like the standard 401(k), the IRS imposes limits on contributions to this account, and you may not be able to open one at all if you earn too much money. The upper limit of contributions is based on modified adjusted gross income.
3. Individual Retirements Accounts (IRAs)
With an IRA, you can invest in a wide range of products, including stocks, mutual funds, bonds, and exchange-traded funds. An IRA operates much like a 401(k) in that contributions are typically tax deductible and the deposits grow tax-free until distributions begin. However, IRAs are distinguished by the sheer number of investment options available. While you can hire someone to invest the money for you, you can also make your own decisions.
An IRA is a great option for someone who does not have access to a 401(k) through work or who has maxed out contributions to their 401(k), as well as individuals who want control over investment decisions. Again, the IRS has clear rules for how much you can contribute to an IRA each year, and there are fees for withdrawing money before retirement.
4. Roth IRAs
Just as with a Roth 401(k), you contribute to a Roth IRA after paying income tax and then never pay tax on the money again. Furthermore, you are not forced to begin taking distributions from these accounts at the age of 70 1/2 as with an IRA or 401(k). As it can sit untouched and continue to grow even while in retirement, a Roth IRA can make a good nest egg for people who have already started to dive into retirement savings.
You can make withdrawals from a Roth IRA before reaching full retirement age without penalty provided that the account has been open for more than five years. You can contribute to a Roth IRA or traditional IRA in the same year, although deposits in both accounts count toward the IRS limit.
5. Special IRAs
There are many special IRAs for individuals in specific circumstances. One is the Savings Incentive Match for Employees (SIMPLE) IRA, which is available for small businesses with up to 100 employees. This account works like a 401(k), although you cannot borrow from it like you can with a 401(k). Plus, the penalties for early withdrawal are steep—up to 25 percent. The money for a SIMPLE IRA comes from pre-tax income, and taxes are paid on the money during retirement.
Another specialized account is the Simplified Employee Pension (SEP) IRA, which is designed for individuals who are self-employed and do not have employees. Contributions to a SEP IRA are fully deductible from taxable income, and the maximum annual contributions are significantly higher than with other tax-favored accounts, since self-employed individuals have fewer retirement savings options.