UPDATED: March 16, 2022
You have heard retirees talk about their company pension. Each month there are usually two checks that come into their accounts: Social Security and their pension benefit. Workers would contribute a specific percentage of their salary to the pension fund in return for specified payments in retirement. Unfortunately, companies are moving away from defined benefit pensions.
Nowadays, workers are given the option of contributing to various retirement accounts, which they generally withdraw in retirement. Another option is fully taxable (and independent from any employer) brokerage accounts and savings accounts. Let’s take a look at these options, along with why you should contribute to each. Generally, it’s better to put savings dollars into tax preferential retirement accounts, then add to general savings options.
Table of Contents
- Start early
- Focus on maximizing 401k & IRAs
- Automate the savings process
Options For Employees
Most private sector employees have two basic types of retirement accounts available: the IRA, and the 401(k). Nonprofit employees have another common option called the 403(b), which is almost the same as a 401(k). Each of these account types has some variants, and we’ll take a look at them too.
401(k) Types and Advantages
Most companies offer their employees a 401(k). Why? They are a tax privileged retirement account that allows employers to contribute to retirement without the ongoing obligations. The retirement burden has shifted from the employer to you (the employee).
Remember about ten years ago when bankrupt companies would cite their pension obligations as a major reason for insolvency? That’s one of the biggest reasons companies changed to defined contribution plans.
With this plan, employees contribute a certain percentage of salary directly from their paychecks. This money is then placed in an account that’s managed by a bank or investment firm. Money contributed into the 401(k) is before tax. This means that the contributions are deducted from your taxable income. You’ll pay taxes on the principal and earnings when money is withdrawn in retirement.
Some employers offer matching funds to employee contributions. Matching contributions increase your savings rate: it’s free money. Depending on your plan terms, the employer’s contribution is yours to keep after a certain amount of time (this is called being “vested.”). Either way, employees are allowed to contribute up to $19,500 each year until age 50, then $25,500 from age 50 on up.
Roth 401(k) accounts behave similarly to their traditional 401(k) counterparts. You can get employer matching funds and the money is invested until you reach retirement age. The same contribution limits apply. However, the taxation works a bit differently: Roth 401(k) savers contribute after-tax dollars. This means that when you take distributions from the account in retirement, it is tax free. For savers who expect a higher tax bracket during retirement, this approach is a great option.
While for-profit companies can offer the 401(k), nonprofits have another option called the 403(b). Basically, they look like a 401(k) and have the same types of limitations. Employers can offer matching contributions and the money is taken directly from employee paychecks. And, like the 401(k) plan, there are both traditional and Roth options available. These plans can also be offered by public school systems who might not offer traditional pensions.
Individual Retirement Accounts (IRAs)
An IRA is money that you’ve saved from your earnings and placed in a tax-favored investment account. Unlike the 401(k) though, this money is put somewhere that you control. In addition, you can invest the money in a wide variety of places. IRAs aren’t tied to your employer, so there aren’t any matching contributions.
With a traditional IRA, your contributions are made with pre-tax dollars. This means that your income is generally reduced by the amount of your contribution. However, you’ll pay taxes on both the contribution itself and any earnings when the money is withdrawn in retirement.
Traditional IRAs can be used by workers of any income level. Contributions are limited to $6,000 per year for those under 50, and $7,000 over 50 as of 2020. In addition, you’ll be required to withdraw money starting at age 72. There’s no tax penalty for money taken out after age 59.5, or for certain qualified expenses. Early withdrawal penalties of 10% apply for premature distributions.
Like the Roth 401(k), contributions are made with after-tax dollars. For this reason, you will have already paid taxes on the money, and when money is withdrawn you don’t have to pay taxes either. This is true whether the money in question is earnings or principle.
Roth IRAs have the same contribution limits as a traditional one, but with a twist: there are income limits. Just one thing to keep in mind: the contribution limit applies across IRA accounts, so if you have a traditional and a Roth then the $6,000 or $7,000 limit is the total amount you can contribute to both.
Options for the Self-Employed
Being self-employed ultimately means that you don’t have as much access to retirement options. For instance, you can’t take advantage of employer matches in the same way as someone who’s an employee does. At the same time, you’re paying self employment tax and (often) individual health insurance. So, what are your options?
401(k) for the self employed
In this case, it’s called a Solo 401(k). So what’s the difference between these and your traditional or Roth employer-sponsored account? Mostly it’s the amount you can contribute. Solos are restricted to just the self employed person and spouse, and as a result you’re allowed to put more money into it.
First, there’s the regular employee contribution of $19,500 or $26,000 depending on age. Then, you can put in an extra 25% of your annual compensation in there. If you’re a sole proprietor then the 25% is deducted from personal income, and if you’re incorporated it’s deducted from the business income. If you can afford to combine these totals, it’s an incredible opportunity to grow your savings fast. Best of all, the Solo has the same protections as an employer-sponsored plan.
While the self employed are allowed to contribute to Traditional and Roth IRAs, there’s a third option available known as the SEP IRA. This one functions similarly to a traditional IRA, in that the money is added pretax and you’ll pay taxes when money is withdrawn.
However, contribution limits are quite different. That’s because you’re allowed to contribute the lesser of $57,000 or 25% of earnings. The top dollar amount changes each year. Because this money is taken from pre-tax income, it saves you (and your business) a lot of money. Also, this one can be used if you have employees. You’ll just have to contribute an equal percentage to the plan for every employee.
Options for Everyone
If you want to save in a way that is more flexible, then there are savings instruments with no tax benefits. For instance, there’s always the regular brokerage account, savings account or Certificate of Deposit.
Traditional brokerage accounts are something that’s used to save up money for any kind of future needs. However, you won’t get any tax benefits. In fact, not only do you need to put already-taxed money in there, but you’ll pay taxes on any earnings (capital gains) and investment income (like dividends). In return for paying taxes, however, you can do whatever you want with your money. If you need to fix the roof, you can pull it from your brokerage account and not worry about it. Or, pay for your kid’s college or wedding. Whatever you want to do, there’s no restriction with brokerage.
While having a brokerage account is beneficial, from a retirement standpoint you should consider contributing to a 401(k)/403(b) or an IRA first. Especially if you get an employer match, go with the 401(k) or 403(b). It’ll let you build savings faster, and hey, free money is awesome.
If you can afford it, max out those contributions. Next, move on to the IRAs.
Finally, you’ll probably want to put some money into an unrestricted savings instrument to help you cover emergencies.