Breaking Down Retirement Accounts
First off I’m going to let you know investing involves risk. So you have to be prepared to possibly lose money, but then again, you can also gain a lot. Before you get into investing it is recommended to have a safety cushion of cash set aside in a secure place like an online savings account or traditional savings account. If you’re fortunate enough to work for a company that has a retirement plan that matches your contributions you should definitely consider enrolling into it.
Employer Sponsored Retirement Plans
401(k), 403(b) or TSA (Tax-Sheltered Annuity) plans have to be offered by an employer.
401(k ) plans are profit sharing plans offered by for profit companies. Ex: Microsoft, Home Depot.
403(b) plans are non-profit plans offered by non-profit companies. Ex: Public Schools, Churches
You can elect to defer a specific amount or a percentage of your salary each paycheck to these plans. The amount you defer can be deducted from your gross income which reduces your overall taxes. When its time for you to retire you have to pay taxes on your 401(k)/403(b) withdrawals. At the age of 70-1/2 you are required by law to make at least the minimum distribution of your account. Unfortunately, there is a 10% penalty if you withdraw money from these accounts before the age 59-1/2 on top of that you also get taxed in your current tax bracket. The annual contribution limit for these plans are $18,000 and $24,000 for individuals older than 50 in the year 2016. This contribution limit varies year by year depending on inflation. What companies like to do to encourage 401(k)/403(b) enrollment is match your contributions up to a certain percent of your salary.
For example, my 1st job matched 66% of my contributions on every dollar I put towards my 401(k) plan up to 6% of my total salary. So if I deferred 6% of a $60,000 salary, that’s $3,600 on my end, which can be deducted from my taxes. Since they matched that $3,600 contribution by 66%, my 401k total for that year would be $5,976. That’s getting a 66 PERCENT return on my money. Let’s say I chose $5,976 worth of great mutual funds, stocks and bonds within my 401(k) account. If all of these funds in my account performed well and brought in an average return rate of 7% my 401(k) total would be $6,200 after 1 year. Overall, I contributed $3600 and got back 72.23% of my investment while also being able to reduce my current taxes.
How old are your parents? Let’s say your mother is 55 years old. Hypothetically speaking, if you started contributing to a 401(k) at age 22 and got a 5% pay increase annually like this until you were in your mother’s age you’ll have over $1.3 million dollars. But you’ll only have to contribute a little over $300,000.
I admit this is a great scenario, but some employers don’t have as many good investment options available to choose from. Then you have to factor in how the market will do. Traditionally the stock market performs well over time, but you just have to weather the storms and don’t panic once you see it crash every now and then. Growing up in the Great Recession had me a little unsure about investing, but since I’m so young I’m going to take that chance. It beats leaving my extra money in a traditional savings account earning 0.01 interests. You cannot open up a 401(k) or 403(b) as an individual unless you are a sole proprietor of your own company.
A sole proprietor can set up an individual 401(k) and make contributions as both the employee and employer, up to a total of $53,000 in 2015 (or $59,000 for someone over 50). The Individual 401(k) is an especially good choice if you are scrambling to build up your retirement savings and can afford to sock away a considerable portion of your earnings. The generous contribution formula lets you put aside more money at a lower income level than you can with a SEP IRA.
A traditional IRA can be established by any individual that earns taxable compensation. They can contribute up to $5,500 a year and $6,500 if you’re over 50. You can contribute to both an IRA and a 401(k), but if you’re covered by a retirement plan at work, you can’t deduct your IRA contributions from your taxable income if you earn more than $71,000 annually (for single filers) or $118,000 (married filing jointly). If you’re not covered by a retirement plan at work, you get the full deduction no matter what your income, unless you file jointly with a spouse who has a retirement plan at work.
Roth IRAs are individual accounts where your money goes tax free in and it’s tax free out when you withdraw it in retirement. Yes that’s right the government can’t touch your money =)
You cannot deduct Roth IRA contributions from your taxes. There is no mandatory age limit you have to make withdrawals. You can also withdraw your contributions (not earnings) anytime without penalty. To contribute to a Roth IRA, you must make less than $131,000 (if you’re single) or $193,000 (if you’re married filing jointly). If your income is more than $116,000 (single) or $183,000 (married filing jointly), your allowed contribution is reduced. You can contribute to both a Roth IRA and a traditional IRA, but the limits apply to your total contribution. You can open up an IRA through any online stock broker.
SEP IRA stands for simplified employee pension and this kind of account is used mostly by the self-employed or small business owners. As the employer, you can contribute up to 25% of your income or $53,000 whichever is less in 2016. Much easier to set up than a Solo 401(k). The money stays sheltered from taxes during your savings years, and what’s additionally appealing is a SEP’s funding flexibility. You can wait to fund the plan until you file your taxes. So if your income turns out to be higher than expected, you can make a large contribution and cut your tax bill. If you have a tough year, you can scale your contribution back.
Simple IRA plan allows small employers with fewer than 100 employees set up IRA’s but you have to match up 3% of your employees’ contributions. An employee can contribute up to $12,500 in 2016, with an extra $3,000 allowed for those over 50. Also, if you need to make a withdrawal from a SIMPLE IRA plan within two years of its inception, the 25% penalty is significantly higher than the 10% fee you’d be charged for early withdrawal from a SEP IRA.
What does ROTH mean?
Roth pretty much means after tax. You can have a 401(k) account and make half Roth contributions and half regular pre tax contributions. But you only can deduct the pre tax contributions from your gross income. If you opened up a 401k account and only made Roth contributions, you wouldn’t have to pay taxes on your contributions in retirement. But your employer matches will always be traditional 401(k) matches. So you would have to pay taxes when it’s time to retire on all of your employer matches. Sorry if this can be confusing, but if you do more research into it you’ll understand it better.
Here’s a few scenarios:
Long Term Employee with 401(k)/403(b) benefits
If you work for an employer that offers a retirement plan. You can contribute at least enough to get the company’s match because that is a guaranteed return on your money.
401(k) $18,000 contribution limit and $18,000 tax deduction or 403(b) $18,000 contribution limit and $18,000 tax deduction.
You can open a Roth IRA $5,500 contribution limit and no tax deduction.
Also, you can open up a traditional IRA but there are income and contribution limits you have to do research on.
Long/Short Term Employee without 401(k)/403(b) benefits
You can open up a Traditional IRA and a Roth IRA.
Roth IRA $5,500 contribution limit and no tax deduction.
Traditional IRA $5,500 contribution limit and $5,500 tax deduction.
If you have more than one IRA, $5,500 is the total you can contribute to all of your accounts, including traditional and Roth IRA.
You can open up a solo 401 (k) elect to defer $18,000 as an employee and 25% of your company’s net profits as non-elective deferrals up to $53,000 total.
SEP IRA $53,000 contribution limit and tax deduction or Simple IRA $12,500 contribution limit and tax deduction.
You can’t open both SEP and Simple plans.
Roth IRA $5,500 contribution limit and no tax deduction.
Traditional IRA $5,500 contribution limit and your deduction may vary depending on coexisting IRA accounts.
IRA’s gives you more flexibility when it comes to the type of investments you want to partake in. Employer sponsored plans are usually limited to whatever the company has to offer. If you’re enrolled in a retirement plan and you leave your current employer, you will have several options of either rolling your account over to another employer sponsored plan, rolling it into an IRA, you can even leave it where it is or cash it out. Despite the information posted on this blog, I still would recommend individual research before you decide to make any investment decisions. When it comes to investing, there’s high risk for high reward but overall it takes patience. Ask yourself how do you want to retire?
P.S. The contribution limits in this article relates to the year of 2016.