Doug West is a retired aerospace engineer and small business owner who writes about investing.
One of the most common reasons people give for not setting up a retirement account is the confusion surrounding account types. Many people are not aware of the differences between different retirement accounts, or how any of them work.
It is understandable to not know the difference between a 401(k) and a Roth IRA, especially if your job does not involve finance or accounting. But putting off retirement planning is a mistake that could have drastic consequences later in your life. It is much better to learn about the different retirement account options early—as early as your 20s.
The sooner you learn about your options, the more time you have to set up an account and start funding it.
How Do Retirement Accounts Work?
There is a misconception that retirement accounts are just like a savings account where you store your money until you hit retirement age—and then you get it all back. The reality is a little more complicated. There are tax considerations and other reasons why opening a retirement account is the best way to save for that portion of your life. There are also limits on how much you can contribute, and when you can withdraw the money in the account.
If you start saving for retirement with a regular investing account, you must pay taxes each time you sell stocks, bonds, or cash out a mutual fund. And if you are selling stocks within 12 months of procuring them, you are looking at very high-income tax rates—anywhere from 15 to 30 percent. Retirement accounts give you a tax break—either during the process of adding money to your account, or when you withdraw all the money from the account at retirement. When you get the tax break depends on the type of retirement account you set up.
Most companies will offer their employees a standard 401(k) retirement savings plan. Contributions to a 401(k) are tax deductible, and any investment earnings on the account are tax-deferred until retirement. It means that you are getting a tax break on your 401(k) until you hit retirement age, or you are ready to cash out the account.
The 401(k) does have a contribution maximum, which sits at $18,500 for 2018. Those who are 50 or older have the option of adding up to $6,500 as a catch-up provision. The maximum contributions do change every year, depending on the guidelines from the IRS.
Employers are allowed to match an employee’s contribution to the 401(k), up to a certain percentage. For instance, an employer may choose to 100% match an employee’s contributions for each year—up to 5% of their annual income. If the employee earns $60,000 a year, the employer would add $3,000 to the 401(k) each year.
Withdrawals from a 401(k) may begin when the individual reaches 59 and a half. Any withdrawals before that age will incur a 10% penalty tax, along with the tax liability. It is also possible to take out a loan on a 401(k), if permitted by the employer. The borrowing amount is up to 50% of the plan’s value, with the maximum being $50,000. Any loan against a 401(k) must be paid back within five years.
A 403(b) comes into play if an individual works for a government organization, or a nonprofit. The income tax treatment, contribution limits, employer matching guidelines, withdrawal requirements and loan provisions are identical to a 401(k) plan.
There is a special maximum allowable contribution (MAC) rule with respect to the 403(b), where individuals who have spent 15 years or more with a single employer may add an extra $3,000 to their annual contribution limit. But it is at the discretion of the employer to allow this added contribution, and many are not aware of its existence.
The investment options are a little bit limited with the 403(b). With a 401(k), almost any type of investment vehicle is permitted. The 403(b) is limited to select mutual funds and annuities.
If you have a 403(b) plan through your employer, but you are switching to a job where they offer a 401(k), it is possible to roll over your plan into a 401(k).
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401k vs Roth IRA
A solo 401(k) is designed for a business owner and spouse who does not have any employees. It is not possible to contribute to a solo 401(k) if you have any employees. There are no age or income restrictions to enroll in this plan. The contribution limit is set to $55,000 for 2018, with an added $6,000 available for those who are 50 or older.
There is an exception to the no employees aspect to this plan: the account holder’s spouse. If your spouse earns an income through your business, you can add them onto the plan. By adding a spouse to the plan, it is possible to double the annual contributions made to the solo 401(k).
Solo 401(k) plan holders have the option between a traditional plan, or a Roth plan. The traditional plan allows for pre-tax contributions, with tax deferred until retirement. A Roth plan permits after-tax contributions, but there is no tax collected on retirement.
Almost any type of investment is permitted within the solo 401(k). Plan holders may invest their money in stocks, bonds, mutual funds, mortgage notes, real estate, precious metals and more. Any withdrawals from the account before the age of 59 and a half will incur strict penalties from the IRS.
Individual Retirement Account (IRA)
An individual retirement account, or IRA, is a type of tax-beneficial investment vehicle that individuals may open if they are hoping to save for retirement. There are a few different types of IRAs—traditional, Roth, SIMPLE, and SEP. Investments that can be made within an IRA include stocks, bonds, mutual funds and more.
Both traditional and Roth IRA accounts are opened by individuals wanting to set up their own retirement savings. SEP and SIMPLE IRAs are set up by small business owners or self-employed individuals.
Contributions made to a traditional IRA account are tax deductible. You are not going to pay taxes on the money you are putting into your traditional IRA, but you will have to pay taxes at retirement. Individual contributions to a traditional IRA must not go beyond $5,500. Those who are 50 or older can contribute up to $6,500 to the account.
Individuals who earn more than $63,000 a year will have to pay some taxes on their contributions to a traditional IRA account. Those with an adjusted gross income that is greater than $73,000 will need to pay tax on all their contributions, provided their employer offers retirement plans. If your employer does not offer any retirement plans, and you make more than $73,000 a year, your contributions will be tax deductible.
The longer you work, the more money you’ll have for retirement. But the longer you work, the less time you’ll have to enjoy that retirement.
The major difference between a traditional and Roth IRA is that your contributions are not tax deductible in a Roth IRA. You will be paying taxes on all your contributions to this account, regardless of your income level. But you will not be taxed on the withdrawals you make from the account at retirement.
Both traditional IRA and Roth IRA accounts have tax free interest and dividends. You will not be paying taxes on the money that you are earning through your investments with either account. The difference is that you are charged tax when you add money to the account with the Roth IRA. The tax bill comes due at the time of withdrawal with a traditional IRA.
Simplified Employee Pension (SEP) IRA
A SEP, or simplified employee pension, IRA is a retirement account that is useful for self-employed individuals and small business owners. Employers can contribute up to 25 percent of your annual income, or $55,000—whatever amount is less. These are the figures for 2018, and they change every year.
It is easier to set up a SEP IRA, as compared to a 401(k). If a small business owner has employees, they must be covered if they meet specific requirements. The good news is that small business owners who set up SEP IRAs for their employees are allowed to deduct contributions to employee plans from their own reported business income. It helps small business owners secure a lower tax rate.
When money is withdrawn from a SEP IRA, it is taxed. The penalty for early withdrawal from the SEP IRA is 10 percent, plus regular income taxes.
The SIMPLE, or Savings Incentive Match Plans for Employees, IRA is another plan designed for small business owners or self-employed individuals. With a SIMPLE IRA, employees are allowed to make contributions to their retirement accounts, and it is necessary for an employee to match those contributions. The plan contributions made by an employer are tax deductible, similar to how the SEP IRA works.
With the SIMPLE IRA, contributions by an employer are limited in one of two ways. They can either match contributions up to three percent of their employee’s compensation. Or they can make a two percent nonelective contribution for each eligible employee. Employees are limited to $12,500 per year in contributions, and $15,500 if they are over the age of 50.
A major difference between the SEP IRA and SIMPLE IRA is that employers are not allowed to make their own contributions with the SEP IRA. It is designed for employers to make all the contributions. SEP IRAs are better suited for businesses where the employees make most of the contributions, while the employer matches to a certain percentage.
The penalty for early withdrawal from the SIMPLE IRA is 25 percent, plus income taxes. This penalty occurs when withdrawals occur before the age of 59 and a half, or if withdrawals start within two years of the plan’s inception. If the SIMPLE IRA is more than two years old, but the individual is younger than 59 and a half, the penalty is 10 percent plus income taxes.
Health Savings Account
A Health Savings Account, or HSA, is a tax-beneficial account that is geared towards individuals who are covered by high-deductible health plans. The goal of the HSA is to help these individuals save for medical expenses that are not covered by their high-deductible health plans.
Contributions to the HSA are made by individuals and/or their employers. There is a maximum limit on the contributions, with the individual limit set at $3,450, and the family limit at $6,850. The minimum deductible limits also change every year, for qualification for a HSA. The individual minimum is $1,350, and the family minimum is $2,700. The maximum out of pocket for individuals is $6,650, while the figure for families is set at $13,300.
Money going into the HSA works similarly to a 401(k). If you are getting the plan through your employer, tax-free contributions are deducted from your paycheck. And your employer may throw in a percentage match to these contributions too. One unique aspect to the HSA is that anyone can contribute to your plan—spouses, parents, extended family, friends, etc.
With so many retirement account options, it is understandable that people are confused when they first start to think about retirement planning. But many of these accounts are for specific situations and purposes. When you look at the number of retirement accounts you are eligible to set up, you will find that it is a lot smaller than this list. It is always wise to contact a qualified investment adviser to get specific advice for your particular situation.
A major decision centers around getting a tax break on contributions or withdrawals. Both have their positives and negatives, and it will be up to you to decide what is best for your circumstances.
It is also possible to open more than one retirement account. For instance, you may decide to go with a Roth IRA, even if you are getting a 401(k) from your employer. But you must keep in mind that tax perks associated with the IRA may change, depending on your income levels and whether you have a 401(k) through your employer.
No matter which type of account is right for you, start saving today as retirement will be here sooner than you think (trust me on this, I know from personal experience).
“Types of Retirement Plans” https://www.irs.gov/retirement-plans/plan-sponsor/types-of-retirement-plans
Tyson, Eric and Bob Carlson. Personal Finance for Seniors for Dummies. Wiley Publishing, Inc. 2010.
Maeda, Martha. The Complete Guide to IRAs and IRA Investing: Wealth Building Strategies Revealed. Atlantic Publishing Group, Inc. 2010.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
Questions & Answers
Question: When must you start taking your money out of a Roth retirement account?
Answer: If you satisfy the requirements, qualified distributions are tax-free.
You can make contributions to your Roth IRA after you reach age 70-½.
You can leave amounts in your Roth IRA as long as you live.
This information is from the IRS website: https://www.irs.gov/retirement-plans/roth-iras
Question: If at age 55, I take out all my money from my 401k, how much of a penalty would I pay?
Answer: Withdrawals from your qualified plan are taxed as ordinary income and may be subject to a 10% Federal tax penalty if taken before the of age 59 1/2. If you left your employer in or after the year in which you turned 55, you might not be subject to the 10% early withdrawal penalty.
© 2018 Doug West
Doug West (author) from Missouri on April 16, 2018:
Thanks for the comment. Sounds like Canada has some similar retirement products.
Mary Norton from Ontario, Canada on April 16, 2018:
Great information. We can't stress enough the need to save for retirement.
In Canada, we have the RRSP which you can move to an RRIF after 70. The money you put in is tax deductible. But we have also the TFSA, Tax-Free Savings Account which is not taxable when you withdraw such savings and gains included. However, there is a limit to what you can put in which is 5,500 a year.