By: The Market Commentators
The decline in traditional pension plans have led to many asking “what’s the best way to save for my retirement?” Most financial advisors agree that a tax-favored retirement savings account is an excellent way to build a retirement nest egg. But that answer leads to a more difficult quandary: “What type of retirement account is best for me?”
Many employers provide their employees the opportunity to participate in what are referred to generically as “qualified retirement plans.” These plans allow employees to voluntarily direct that a portion of their paycheck be contributed to a retirement savings account, which in turn can be invested in stock and bond funds.
Retirement savings accounts can be divided into two broad categories; those sponsored by an employer, and those you set up for yourself.
Employer Sponsored Retirement Plans.
A traditional 401(k) is the most common type of retirement plan. Contributions are made on a pre-tax basis and the earnings grow tax-deferred, meaning you do not have to pay taxes on what you invested or earned until you withdraw the funds from the account, the full amount of which must be included in taxable income when received. And, subject to limited exceptions, withdrawals prior to 59½ years of age will trigger a 10% early withdrawal penalty.
There are limits on how much an employee can contribute to their 401(k) accounts. For 2021, contributions are limited to $19,500. However, an additional $6,500 catch-up contribution is allowed for anyone who is 50 or older.
Employers can also make contributions to their employee’s 401(k) retirement savings accounts. Typically, this is done on a matching basis, such as contributing 50 cents for every dollar the employee contributes, up to 6% of the employee’s total compensation.
Roth 401(k) plans are similar to traditional 401(k)s, with one big exception; contributions to a Roth 401(k) are included in taxable income when contributed. However, withdrawals from a Roth 401(k) are entirely tax free. In other words, amounts earned on investments held in a Roth 401(k) savings account (such as interest income, dividends and capital gains) are not taxed, whereas such earnings are taxed as ordinary income when distributed from a traditional 401(k) account.
Employers can also match contributions to a Roth 401(k), but the amount that is being matched will be placed into a traditional 401(k). Roth 401(k) accounts can also be rolled, tax-free, into a Roth IRA account (discussed below).
Small businesses and self-employed persons can establish a simplified retirement plan referred to as a SEP IRA, which is simpler to establish and easier to maintain than a 401(k). With a SEP-IRA, the business makes contributions to IRAs opened in the name of each employee. The employee then decides how the IRA is to be invested.
An employer can contribute as much as $58,000 to an employee’s SEP IRA account in 2021. However, these plans require proportional contributions for all full-time employees, meaning the employer must contribute the same percentage of wages to each employee’s IRA.
Government and Nonprofit Employers.
If you work for a government agency, then you are most-likely able to participate in a government-sponsored pension plan. Unlike a 401(k), where the employee’s contributions are invested in a separate account and paid out for their benefit until the funds are exhausted, a pension plan provides employees with a defined benefit after they retire that is payable for their lifetimes.
Government employees can also contribute to a supplemental savings plan called a 457(b) plan. A discussion of these plans is outside the scope of this article.
Nonprofit organizations (such as schools, hospitals and charities) can sponsor either a 401(k) plan or a 403(b) plan for their employees. Differences between the two plan types include:
- 403(b) plans typically allow employees to enroll in the plan immediately upon their employment regardless of age, whereas 401(k) plans typically have a waiting period and age requirement.
- 401(k) plans have a wide-range of investment options. 403(b) plans are restricted to mutual funds or annuity contracts issued by insurance companies.
- 403(b) plans are exempt from nondiscrimination testing, which means highly compensated employees don’t have additional limitations on how much they can contribute.
Perhaps the plan most individuals are familiar with is Individual Retirement Accounts, or IRAs. Anyone with earned income can open an IRA account with a financial institution of their choosing, and can contribute up to $6,000 to the IRA in 2021 ($7,000 if you're age 50 or older). You can contribute to an IRA even if you participate in an employer-sponsored retirement plan, but in that case the IRA contribution might not be tax deductible, depending on your taxable income level.
As in the case of 401(k)s, you can choose to establish either a traditional IRA or a Roth IRA.
1. With a traditional Individual Retirement Account (IRA) contribution earnings grow tax-deferred. And, if you're not covered by a retirement plan at work, you can deduct the entire amount of your IRA contribution from your taxable income. As a result of changes made by the SECURE Act, you can make contributions to a traditional IRA regardless of your age, however, Required Minimum Distributions (RMD) must start no later than age 72.
2. Unlike traditional IRAs, contributions to Roth IRAs are not tax deductible, distributions to you are entirely tax free (provided the funds withdrawn were held in the account for at least five years). So, as in the case of a Roth 401(k), investment returns generated inside a Roth IRA are not taxable.
As of 2021, any individual with taxable income of $140,000 or less per year (or $208,000 if married filing jointly) can contribute directly to a Roth IRA (although there are strategies that can be used to circumvent that limitation).
Required Minimum Distributions.
Distributions from both traditional IRAs and employer-sponsored retirement plans are required to begin by April 1st of the year that follows the account owner’s 72nd birthday. The amount that must be distributed increases as the account owner ages. The IRS publishes tables that can be used to determine the amount that must be taken in a given year.
The required minimum distribution rules do not apply to Roth IRAs. As a result, a Roth IRA can allow for additional tax-free compounding, which in turn can dramatically increase the amount the owner of such an account can leave to his/her heirs. What’s more, amounts the heirs receive are also tax-free!
As you can see, there is an array of different types of retirement savings accounts; each with their own benefits and complexities. If you would like to discuss any of these planning techniques further, please feel free to contact Andrew Willms @firstname.lastname@example.org.