Understanding Retirement Accounts and Choosing the Best One for You
Saving for retirement can be scary. Most people know they need to save for retirement, but getting started can be complicated and confusing, especially if your employer doesn’t offer a retirement plan. Knowing which mix of plans to choose and their various rules can be overwhelming, but it doesn’t have to be if you take your time and learn about the options available.
Listen to this week’s episode of the rich & REGULAR podcast about demystifying retirement and keep reading as we discuss different types of retirement plans.
Types of retirement plans
For many people, retirement planning starts when they get their first ‘real’ job and continues throughout their careers with various rollovers or secondary accounts added. Although many people rely on their employer-sponsored 401(k) for the majority of their retirement planning, there are other options available that don’t require traditional employment or that can be used to complement your employer-sponsored plan.
Retirement plans are generally divided into pretax money (i.e., funds from your gross paycheck) which helps lower your income tax bill while working, and post-tax money (funds taken from your net paycheck) that you’ve already paid taxes on.
A good mix of pre and post-tax accounts is usually necessary for retirement planning and offers protection from higher taxes now and in the future. The following is a selection of available retirement account options, but others are available, each with different requirements and advantages. Work with a retirement professional to help you find the right mix of accounts for your situation.
Traditional 401(k) and Roth 401(k)
The most common retirement plan in the US is the 401(k). This employer-sponsored retirement plan takes pretax money and invests it until you’re ready to retire. You can withdraw funds without penalty when you reach age 59½, although you’ll likely pay taxes on the contributions and the growth. Some employers offer matching contributions up to a certain percentage. If you have access to a 401(k) through work, be sure to contribute enough to get the entire match.
There are also Roth 401(k)s, which are still employer-sponsored but funded with after-tax money. You likely won’t pay taxes on that money when you withdraw it in retirement, assuming you’ve made a qualified withdrawal and meet the account requirements.
In 2022 you can contribute up to $20,500 in your 401(k) or Roth 401(k), plus an additional $6,500 if you’re over age 50 as a catch-up contribution.
Alternatives to employer-sponsored plans
What do you do if your employer doesn’t offer a retirement plan, you’re self-employed or just want to supplement your retirement investments? Consider using one (or more) of the plans below to help you plan for retirement:
A Traditional Individual Retirement Account is similar to a 401(k), except it isn’t offered through an employer. You contribute pretax money, and it grows tax-deferred until you reach retirement age. When you take the money out of the account, you’ll pay taxes on contributions and the growth. The amount you can save in an IRA is less than a 401(k). You can only save $6,000 per year in 2022, or if you’re over age 50, you can contribute an additional $1,000 ($7,000 total) as a catch-up contribution.
Roth IRAs are similar to traditional IRAs, except that you fund them with after-tax dollars. When you withdraw the money in retirement, you likely won’t have to pay taxes on either your contribution or the growth, assuming you’ve made a qualified withdrawal. Roth IRAs have the same contribution limits as a traditional IRA.
A SEP IRA, or Simplified Employee Pension, lets you contribute to a retirement account if you’re self-employed or a small business owner. If you qualify for a SEP IRA, you’ll have higher contribution amounts than a traditional or Roth IRA—25% of your annual compensation for the year or $61,000 (for 2022), whichever is less. Work with a financial planner or tax consultant to see if you qualify for one of these accounts.
Taxable brokerage account
Brokerage accounts are usually straightforward to set up and have low (or zero) account minimums, depending on the brokerage firm you use. While you may have to pay capital gains tax on earnings, you can withdraw the money at any time, with fewer restrictions. Brokerage accounts can be a great way to save for long-term goals like buying a house or even as a cushion to your immediate emergency fund, especially if you can ignore the day-to-day market fluctuations and invest long-term.
Brokerage accounts can be a helpful investment tool, but you probably don’t want to use one exclusively for your retirement savings. Make sure you have a good mix of taxable and tax-advantaged accounts as you plan for retirement and work with a professional.
General wisdom says that a secure retirement plan has a mix of both pretax and after-tax accounts. Be sure that you work with a retirement and financial planner to develop a plan that meets your needs. Even though planning for retirement isn’t exciting, making sure you’re covered for any eventuality offers irreplaceable peace.
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