The basic idea behind any retirement plan is to put some money into different investments and to live off what those investments generate in retirement.
How much your retirement portfolio will grow depends not only on the amount of money you save but also on your choice of retirement accounts.
You can choose from three different types of retirement accounts:
- The 401(k) and traditional IRA. These are tax-deferred accounts.
- The Roth IRA and the Roth 401(k) plan. These are tax-free accounts.
- Brokerage investment or savings bank account. All earnings on your investments are taxable.
The most common ways retirement accounts are opened:
- Through your employer
- Through yourself, if you are self-employed
- Through financial institution on your own
Employer-Sponsored Retirement Account – 401(k)
401k plans are retirement plans offered by employers. And a 401k account is tied to your employer because the employer sponsors the plan. A 401k is just the name of your retirement savings account where you save money for retirement.
A 401(k) plan is the most common tax-advantaged retirement plan. Your contributions to the plan are made automatically with your pre-tax dollars. Compared to other retirement plans, a 401(k) plan allows high contribution amounts of up to $19,500. And if you are age 50 or older, the catch-up contribution is an additional $6,500. So, you can save a total of $26,000. (in 2021). Your employer may or may not match a portion of what you invest. But if an employer match is available take it because it is free money for you.
The best part is that your contributions will grow tax-free for many years which allows the compound interest to kick in and start working its magic. After all, a 401(k) plan helps your retirement savings grow as in a tax-sheltered account.
You will start paying taxes on money invested only after you retire. If you withdraw money before the age 59 ½ you will pay a 10 percent penalty fee and taxes on your withdrawal. At age 72 you will be forced to start taking money out of tax-deferred accounts because IRS is eager for you to pay taxes on the money. If you do not take your RMD (Required Minimum Distributions) on time, you will face a 50 percent penalty fee.
I recommend reading my posts:
- A Guide to Understanding a 401(k) Plan
- Smart Ways to Take Money out of Retirement Accounts
- Why You Need to Max-Out 401(k) Plan
Self-Employed Retirement Account – Solo 401(k)
Solo 401(k) or Self-Employed 401(k) is an individual retirement plan for someone who is self-employed and does not have any full-time employees besides a family member. Solo 401(k) rules are similar to a regular 401(k), but a bit complex to set up. You can open an account with any online brokers. But you will need an Employer Identification Number (EIN), an account application, and the company rules for your 401(k).
Traditional IRA Retirement Account
The traditional IRA, which stands for Individual Retirement Account, works the same as a regular 401(k), but no employer is involved. You can open an IRA on your own with any online brokers. Online brokerages such as Fidelity, Schwab, and Vanguard are good choices. And you can have both 401(k) and IRA accounts.
In 2021 you can contribute up to $6,000 a year or $7,000 if you are over 50. The money that goes into an IRA account must be from the earned income (money you make from working and not as gift money).
The contributions for IRAs are much lower than for 401(k) plans. And there is no employer matching contribution since there is no employer sponsoring the plan.
If you take money out of your IRA before you reach age 59½, you will face a 10 percent penalty fee (the same as with a regular 401(k). In addition to that, you will have to pay federal and state income taxes you owe on the withdrawal.
There are a few exceptions to this rule. You can avoid the penalty if you withdraw the money for the following reasons:
- Buying a home for the first time
- Qualified education expenses
- Health insurance (if you are unemployed)
- Medical expenses that were not reimbursed
At age 72 you will be forced to start making withdrawals from your traditional IRA (the same as 401(k) rules).
Roth IRA Retirement Account
Roth retirement accounts basically mean that you pay taxes upfront when you put the money into the account. But you will pay zero taxes when you take the money out.
You are only allowed to put money into a Roth IRA if your income is below a certain limit. If you meet that criteria, your annual Roth IRA contributions in 2021 are $6,000 for people under the age of 50 and $7,000 for people over 50.
If you can contribute to a Roth IRA, it is a great way to save more money for retirement. Unlike a traditional IRA or 401(k), the IRS does not require you to make RMD withdrawals from a Roth IRA account. The money can sit and grow there as long as you want it. And it can be passed to your heirs.
If you turn 59 ½ you can withdraw money from your Roth IRA tax and penalty-free. However, you may have to pay taxes and penalties on earning in your Roth IRA if you have had it less than five years.
But if you are age 59 ½ and older and met the five-year holding requirement, you can withdraw money from a Roth IRA account with no taxes or penalties.
You can open a Roth IRA account at any financial institution including online brokerages such as Fidelity Investments, Vanguard, Charles Schwab, and TD Ameritrade.
Roth 401(k) Retirement Account
A Roth 401(k) is a type of 401(k) that allows you to make after-tax contributions and then when you retire to take tax-free withdrawals. On the other hand, a traditional 401(k) allows you to make pre-tax contributions and get taxable withdrawals in retirement.
I recommend you check to see if your plan has a Roth 401(k) option. Everyone should be eligible if the plan has a Roth option. If your employer offers both a Roth 401(k) and a traditional 401(k) you can split the contributions. I have both accounts – a traditional 401(k) and a Roth 401(k) and I split the contributions 50/50.
A Roth 401(k) is one of the best options for you because it does not have income and contribution limits as a traditional Roth IRA. As with a traditional Roth IRA, your contributions come from your after-tax paycheck rather than pre-tax salary as a 401(k). Your contributions and earnings in a Roth are never taxed again if you follow the rules and remain in the plan for at least five years.
With a traditional Roth IRA, you are not required to take RMDs at a certain age. However, with Roth 401(k) you have to start taking RMDs at age 72. The good news that you have an option to roll the money over from a Roth 401(k) to a Roth IRA.
Both Roth IRA and Roth 401(k) accounts allow tax-free growth on your retirement savings and tax-free retirement income. But there is a difference in rules for taking money out before retirement.
Brokerage account – taxable account
A brokerage account can also be a type of your retirement account where you keep your savings for growth. The main difference between a brokerage account and your other retirement accounts that there are no any tax advantages.
Except for certain select investments, such as municipal bonds, all earnings are taxable. So, if you make money because your investments go up in value or receive dividends, this income will be taxed. In addition to that, you will have to pay capital gains taxes when you sell your investments.
You can open a brokerage investment account at any financial institution including online brokerages such as Fidelity Investments, Vanguard, Charles Schwab, and TD Ameritrade.
The good news that there is no limit to how much you can invest in a brokerage account. This account works great for people who want to build wealth through the stock market.
Also, there is no penalty fee if you decide to withdraw your funds before the age of 59 ½ or forced RMDs at age of 72.
- How to Set Up Your Retirement Portfolio
- 5 Basic Rules of Investing for Women
- How to Protect Retirement Savings During Coronavirus
- Are You Financially Prepared to Retire?
Putting It All Together
Retirement accounts like 401(k), IRAs, Roth IRAs offer us different tax benefits. Even there are differences between these types of accounts, they basically work the same way in everything else. The main idea is that you make contribution throughout your life so that when you retire you have enough money to live off your investments.
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