Far too many people put off saving for retirement because the process can seem costly and confusing. Unfortunately, investing in your retirement is a big job, especially if you hope to set aside enough to travel or retire early. Understanding the various types of retirement options is the first step toward retiring successfully.
Traditional Individual Retirement Account (IRA)
IRAs are tax-advantaged retirement accounts that maintain your chosen investments. A traditional IRA is tax-deductible during the year you make your wage or salary contributions. The current contribution limits on IRAs is set at $6,000 per year, plus an extra $1,000 if you’re 50 or older.
As of 2020, you must start taking the required minimum distributions from a traditional IRA at age 72. There is also a penalty for withdrawing funds earlier than six months before you turn 60.
Traditional IRAs are best suited to people who want to lower their tax bill now and make deductible retirement contributions, or those who earn too much money for a Roth IRA.
Roth IRAs are similar to traditional IRAs in terms of contribution limits, but there are notable differences. Roth IRAs offer a tax advantage when you withdraw the retirement funds rather than when you invest the money. Your money also grows tax-free, which is a nice advantage.
These retirement accounts are great for transferring wealth to your heirs because Roth IRAs do not have a required minimum distribution; instead, you can pass the entire account along to a beneficiary, making the Roth IRA ideal for estate planning. Roth IRAs offer more flexibility for early withdrawals, fewer restrictions for retirees, and provides greater opportunities for tax diversification when paired with an employer-provided 401(k).
While you must have earned income to open a Roth IRA, the account phases out once your earnings reach $122,000 (or $193,000 jointly). Roth IRAs are great for people who are currently in a low-income bracket and are looking for a flexible retirement account.
A 401(k) is an employer-provided retirement account you can get as part of your employee benefits package. Some companies also offer employer-match contributions, meaning that whatever amount you contribute annually, your employer will also contribute the same amount, which can help your funds grow quickly.
401(k) accounts offer significantly higher contribution limits than IRA accounts. Money is usually taken from your paycheck and deposited into your 401(k) automatically, taking any guesswork out of saving for retirement. As of 2019, the annual contribution limit for an employee is $19,000, and those over 50 can contribute an extra $6,000 per year.
401(k) retirement plans are best for people who work for companies that provide them. They’re also useful for those who find retirement planning confusing or lack the self-control to save.
Just keep in mind that 401(k) plans may have maintenance fees or other charges set by your employer. You’ll also have to deal with penalties for withdrawing funds early, although you can typically borrow from your account in the form of a loan that you pay back with future paychecks.
One of the lesser-known individual retirement accounts is the Savings Incentive Match for Employees (SIMPLE) IRA. This retirement plan is reserved for small businesses with up to 100 employees.
Despite the name, SIMPLE IRAs are more similar to 401(k) plans. Small-business employees make contributions using automatic, pre-taxed paycheck deductions and the money grows in the account until retirement. It’s then taxed upon withdrawal.
The downside to the SIMPLE IRA is that you can't borrow from the account like you can a 401(k). SIMPLE IRAs also have steep penalties if you take distributions within two years of starting the account or before age 59-and-a-half.
If you’re self-employed with no employees, you should consider contributing a portion of your income to a Simplified Employee Pension (SEP) IRA.
SEP IRAs are fully deductible from your taxable income and offer high maximum annual contribution limits. Currently, the annual contribution limit is set at 25% of your income or $56,000, whichever figure is less.
This type of retirement account is also attractive for small-business owners who want to provide some form of retirement options to their employees. That is because SEP IRAs do not have the start-up or operating costs associated with other employer-sponsored plans.
Although SEP IRAs are a great option, there are a few eligibility requirements worth noting. Contributors must be at least 21 years old and have at least three years of employment. On the positive side, SEP IRAs allow employers to skip their contributions when business is slow.
Profit-sharing plans (PSPs) are retirement plans funded by employer contributions that provide employees a share in the company’s profits. Essentially, an employee can expect to receive a percentage of his or her employer’s profits based on company earnings.
Income taxes on PSPs are deferred and assessed from fund distributions in retirement. An employee can contribute 25% of their pay or $56,000 to the account, whichever figure is less. The great thing about PSPs is that companies typically provide them in addition to other retirement plans, such as 401(k)s, which can make contributing to one or the other completely voluntary for the employee.
Defined Benefit Plan
More commonly known as pensions, defined benefit plans are employer-provided retirement plans that calculate an employee’s benefits by factoring in age, length of employment, and salary. As more companies shift to the 401(k) model, defined benefit plans have become increasingly rare.
Pension plans offer deferred taxes that are assessed on fund distributions in retirement, and the contribution limit is determined by the employer. The biggest advantage of defined benefit plans is that they provide tax benefits to both the employee and employer, creating a fixed payout in retirement that retirees can rely on. Employers can expect costlier upkeep, however, which is why pensions have fallen out of favor.
Retirement and estate planning should not wait. Start investing in your future now so you can enjoy a comfortable retirement on down the road. Contact 3D Wealth Advisors for more information on how to get started.