Do you often feel that retirement planning is like mastering another language? It really doesn’t have to be that way. Contrary to popular belief, retirement plans are easy to understand although they do each have their own limitations. Your modified adjusted gross income will be the basis of these limitations, while others involve a cap on the amount of yearly contribution you make.
Tax treatment of withdrawals, as well as the age at which you can withdraw and must take withdrawals without owing a penalty, depends on the types of plans as well. You will know which one is best for you if you try to compare them.
401(k) Plans
A 401(k) plan is offered as an employee benefit because it’s a workplace retirement account. You are able to contribute a portion of your pre-tax paycheck to tax-deferred investments through this account. Let’s say, you earned $75,000 and contributed $5,000 to your 401(k), you will be taxed on $70,000.
Until you withdraw the money in retirement, investment gains grow tax-deferred. If before you reach the age of 59 ½ you withdraw the funds from the plan. However, you may have to pay a penalty of 10%. You will also be owing federal and state income taxes to your withdrawals. But if you are in a cash emergency, you can get some plans that offer 401(k) loans as well.
Some employers match employee contributions to a 401(k) although it’s not that usual. It’s typically up to 6% although, over a period of years, it might “vest” its contributions. In other words, if you leave the company before the prescribed period of time has elapsed, you wouldn’t be able to take your employer’s contributions with you. However, you will always own the contributions you made to the plan.
You could be ignoring a significant employee benefit if you’re not contributing up to the company match. You effectively get free money with an employer match. These plans being offered by employers typically mean you can make contributions through automatic payroll deductions which makes you save money a little easier.
These types of plans have investment choices that are often limited. Their management and administrative fees can be high as well. Every year, the IRS imposes contribution limits although limits for 401(k) plans are more generous compared to other plans: in 2020 it’s $19,500, which is an increase from 2019 at $19,000. If you’re 50 or older, this increases to $26,000.
Included to the variations of this type of account is the 403(b), a similar account available for educators and nonprofit workers, and 457(b) plans, which are available to government employees.
Individual Retirement Accounts (IRAs)
An IRA is an investment account that is tax-favored. If you want to invest in stocks, bonds, mutual funds, ETFs, and other types of investments you can use the account after you deposit money into it. You also make the investment decisions yourself unless you want to hire another person to do it for you. If your employer doesn’t offer a retirement plan you might consider investing in an IRA. If you maxed out your 401(k) contributions for the year, this is also a great choice.
In 2020, you are allowed to contribute up to $6,000. If you’re age 50 or older, this increases to $7,000. They grow more quickly if you pay no taxes annually on investment gains.
For taxpayers who don’t have a 401(k) retirement account, they can deduct their IRA contributions on their income tax returns. This means their taxable income for that year can be reduced. There are some restrictions depending on income. When the money is withdrawn in retirement, you pay income taxes on your contributions and on gains.
Roth IRAs
Roth IRA contributions are made with after-tax dollars which makes them different from a traditional IRA. But there will never be any taxes on any money generated within the Roth.
As long as you wait until five years have passed since your first contribution, you can withdraw contributions you’ve made to a Roth IRA before retirement age without penalty. You don’t have to start taking withdrawals at age 701/2 as you are with traditional IRAs, 401(ks), and other savings plans for retirement.
If you’re just starting out and you think your income will grow, putting money in a Roth is a great place to invest extra cash. If you want, you can also contribute to both an IRA and a Roth IRA but you have to remember that you can’t exceed the $6,000 contribution limit for the year.
Roth 401(k)
The features of the Roth IRA and 401(k) are combined in a Roth 401(k). Employers are normally the ones being offered it and it’s pretty new. As with a Roth IRA, the contributions you make come from your paycheck, after-taxes, rather than your salary that still hasn’t had your taxes deducted.
Since there is no income limit with a Roth 401(k), it’s one of the best plans you can get. Although the annual contributions are taken after-tax dollars, it’s still the same as a traditional 401(k). As for withdrawals, they’re the same as Roth IRAs but the rules for distribution are similar to that of a traditional 401(k).
Need more information about retirement plans? Consult a financial advisor and a tax professional to give you a complete run-down of all the best plans you’re qualified for.
