One of the most confusing things is what type of account to get to start saving for retirement. I will quickly go over Roth & Traditional IRAs, annuities, and 401ks/employer plans. Most retirees would say the most important thing is to start saving now.
Most retirement accounts can be broken down into two distinct categories: tax-deferred and after-tax.
The first one is called “tax-deferred.” With these types of accounts, you pay taxes on the money when you withdraw it. Popular types of deferred accounts are 401ks and IRAs. The downside is that you typically have to wait until you are 59 1/2 before accessing the money saved. Also, you will be paying taxes on the funds when you withdraw it. However, the funds will grow without taxes.
The second is called “after-tax.” These types of investments are when you pay taxes on the money, and it grows tax-free. An example is a ROTH IRA. There are still penalties for withdrawing before 59 1/2, but when you make a withdrawal, you don’t have to pay taxes. This could be a massive advantage if you are planning to have a significant income during retirement. Besides, taxes are expected to increase because of increased spending by the government in the future.
Is 401K A Good Retirement Account?
For most people, a 401k or employer type plan is a great way to start saving for retirement. It is the one that is the most popular and easiest to begin. 401ks accounts are tax-deferred, so the money grows tax-free. Besides, most employers pay a percentage of what the employee contributes. An example is a 3% match. When an employee pays 3% into the 401k, the employer pays 3%. So it is essentially free money for employees. Most financial advisors tell clients to pay at least the matched percentage into their 401k.
The money you put into your employer’s plan is not included in your income for tax purposes, so it is not subject to the same tax rate as your regular income. The contribution limit varies from plan to plan, but the cap for 2020 is about $19,500, and the cap is raised every year.
In addition to the normal contribution limit outlined above, under 50 can make an additional $6,000 in catch-up contributions by 2020. The catch limit will be increased every year until the cumulative effect of inflation indicates that an increase is needed.
What is a Traditional IRA or Individual Retirement Account?
If you are self-employed or don’t have an employer plan, you may want to consider opening a traditional IRA. You can open one online and pick the investments. It is similar to the 401k in that it is tax-deferred. You can deduct the money paid into an IRA but will pay taxes when you get the money out. The limits are $6000 for 2020 people under 50 and $7000 for people over 50.
What is a ROTH IRA or Individual Retirement Account?
A ROTH IRA account similar to a traditional IRA, but you do not receive tax deductions for contributions to IRA, but you pay a tax on your income when you withdraw money. It grows tax-free. For many people, this a great way to save for retirement and not worry about taxes in the future.
If you don’t need the money, you can keep growing in this cheerful, tax-free way, and if you don’t need it, you can keep growing it. It has very similar limits and restrictions.
Retirement Account Bottomline
For most people, putting money in a 401k is a very wise decision if the employer contributes. If you think you may continue working in retirement or have a high income, you should consider looking at a ROTH IRA.
|401k||Deferred||Employer Match & Higher Contribution Limits||No Control of Investment Options|
|IRA||Deferred||Picking Own Investments||Lower Contribution Limits|
|ROTH||After-Tax||After Tax & Picking Own Investments||Lower Contribution Limits|
|Regular||Taxed||Pick Own Investments||Taxed|
The best way to start is to sit down with a financial advisor and/or CPA to explore options and set up a plan.