Saving up for retirement is something every individual should start thinking about the moment they start working. It doesn’t matter whether you’re 25 or 45, it’s never too early to plan for your golden years.
In this article, we’ll look at a few popular retirement accounts that you can start ‘investing’ in from the time you start work. Millions of Americans are confused by these different accounts… but we’ll simplify them here.
- 401(k)
This is an employer-sponsored savings account.
For example, your employer may match a certain percentage of your income if you contribute to your 401(K). Let’s assume you’re earning 75K a year and your employer has a 5% match.
5% of 75K is $3,750. If you contribute $3,750 to your 401(k), your employer will contribute another $3,750 to match yours. That makes this one of the best ways to ramp up your savings.
However, the minimum withdrawal age for your 401(k) is 59 and a half years. If you try and withdraw your money earlier, you will need to pay a penalty.
The benefits of a 401(k) are tax advantages, lower fees and creditor protection. Depending on your risk tolerance, you may invest your 401(k) savings in conservative mutual funds, aggressive growth funds and so on.
Money contributed to a 401(k) is taken from your gross income before taxes. Now you have less taxable income and pay lower taxes. This is known as tax-deferred. You’ll only pay taxes on your savings when you withdraw them.
When your 401(k) reaches a substantial amount, you may wish to hire a financial advisor to help you manage your funds.
Currently, an employee can contribute up to $19,500 a year to their 401(k). It’s best to use this retirement savings vehicle wisely and max it out.
- IRAs
IRAs stand for individual retirement accounts. The difference between an IRA and a 401(k) is that your employer is NOT involved with an IRA. You’ll be the one setting it up and contributing to it.
Since there’s a yearly limit to contributing with the 401(k), if you have more money you wish to save, you can deposit it into an IRA. You’ll have a wider variety of bonds, stocks, etc. you can invest in.
People often get confused with IRAs because there are several different types such as traditional IRA, Roth IRA, SEP IRA and so on. So let’s see what they are.
*Traditional IRA – A traditional IRA allows you to deposit pre-tax dollars into a retirement account for investment. This is the key difference to take note of – you DO NOT pay taxes on your traditional IRA deposits.
You’ll pay them later upon withdrawal. So, this is a tax-deferred account. The good news is that if your tax rate is lower at retirement, you’ll pay less in taxes.
Your contributions are limited to $6,000 a year if you’re below 50, and $7,000 a year above 50.
*Roth IRA – Contributions to a Roth IRA are tax deductible. So, you’ll be paying taxes on your deposit. However, upon withdrawal, your money will be tax free, since you already paid taxes earlier.
This type of IRA is better for people whose income increases with age, which puts them in a higher tax bracket over time. So, you’ll save on taxes when you pay them earlier.
Your contributions are limited to $6,000 a year if you’re below 50, and $7,000 a year above 50.
If you’re earning more than $139,000 yearly, you’ll not be allowed to open a Roth IRA. Couples should not have a combined income that exceeds $206,000. If your contributions exceed the limit, you may have to pay a 6% excise tax.
The restrictions on a Roth IRA account are to prevent high-income earners from enjoying tax advantages and benefiting more than the average income earner.
*SEP IRA – This stands for simplified employee pension. If you’re self-employed or a business owner with no employees (except your spouse), you can contribute to a SEP IRA.
Your contributions will be limited to 25% of your net earnings. Contributions to SEP IRA are tax-deferred.
There are several other IRAs and retirement accounts, but the ones above are the most popular. If you truly want to max out your retirement accounts, you should speak to a financial advisor.
This one-time investment in their services will educate you more on the topic than any book or article. You’ll need to learn about distributions and the benefits and disadvantages of the different types of accounts.
You may also want to contribute to both a 401(k) and an IRA each year. A qualified financial advisor will advice you on the limits and how to contribute in the most effective way.
- Important note
While saving for retirement is well and good, there are times when you’ll need to delay your contributions.
If you’re dealing with lots of credit card debt and so on, your goal should be to first pay off these debts. The interest rate on revolving credit will always be higher than what you’d earn in your retirement accounts.
Paying off debt is one of the best ways to indirectly increase your retirement savings in future.
Another point to note: you should have saved up about 3-6 months’ worth of income (or expenses) in an emergency fund, just to be prepared for unforeseen situations.
Money in your retirement accounts lack liquidity and early withdrawal will mean paying a penalty. So you should have cash saved up first.
Health insurance is also a must. You must have good coverage before you start investing your money. Medical bills can wipe you out and lead to financial ruin, if you’re unprepared. So, be well-insured. Once these are taken care off, you can save for retirement accordingly. That’s the most ideal way to go about it.