When it comes to your money and building wealth your number one tool to achieve it is retirement accounts, but with everyone talking about them at times it sounds like another language- let's break down Retirement Accounts in simple terms and why they are so important.
EVERYTHING THERE IS TO KNOW ABOUT RETIREMENT ACCOUNTS
401(k)
You're probably very familiar with 401(k)s since this is the most talked-about retirement account since it's offered by your employer.
A 401(k) is a retirement savings plan sponsored by an employer. It lets workers (you) save and invest a percentage of their paycheck BEFORE taxes are taken out. Taxes ARE NOT paid until the money is withdrawn from the account/retirement.
The top benefits of a 401(k) are:
-Tax-deferred account meaning you pay taxes later on when you retired and take out the money.
- 99% of the time your employer matches a certain %, meaning they give you "free money" just because you're investing and participating.
In simple terms- think of a 401(k) as a savings account that you "save/invest" in with pre-tax money that comes out of your check (before you see it) and the money is invested in the market so you could have something to fall on once you retire.
TOP TIPS
- Start contributing as soon as you start the job- so you won't see the money that comes out & you won't miss it.
- Increase your contributions each year by at least 1%. If or when you get a raise- increased your contributions.
- It's recommended to contribute at least 15% of your gross income- but if you can do more go for it. If you can only start with a percentage to get the match from your company- that's fine too
PRO TIP: Contribute at least up to the percentage your employer matches. Meaning if your company will match 100% up to 6%- you should also contribute 6% or 7% so you can get the equivalent as "free money" from your employer.
ROTH 401(k)
A Roth 401(k) is essentially the same as the normal 401(k)- it's also offered by your employer and the money is coming out of your paycheck. The difference here is that a Roth 401(k) is funded with after-tax dollars. Meaning you will NEVERpay taxes on the money you contribute since you are paying the taxes before you invest the money.
Contributions and earnings in a Roth 401(k) are never taxed if you remain in the plan for at least 5 years and do not do any premature withdrawals (you wait until retirement to take the money out).
NOTE: If you're employer matches any of your Roth 401(k) contributions it will be done pre-tax and not after-tax.
IRA
An IRA (Individual Retirement Account) is a tax-favored investment account- meaning is funded with pre-tax money and you do not pay taxes until you retire. With an IRA you are able to buy and sell investments. You open an IRA through a brokerage (Fidelity, Charles Schwab, Vanguard, Merrill Edge, TD Ameritrade, etc).
PROs of an IRA
- Tax-deferred (you don't pay taxes until you take the money out)
- Is not sponsored by your employer- you can open one yourself
- Can open even if you have a 401(k) through work
CONs of an IRA
- Penalties of at least 10% if taken out before the age of 59 and 1/2
- Taxed on the money you take out (both contributions & earnings)
- Contributions limit for 2019 & 2020 is only $6,000
ROTH IRA
A Roth IRA is a type of IRA in which you contribute towards with after-tax money and all of your future withdrawals (on your contributions) are tax-free- even if taken out before retirement. The earnings on your Roth IRA are also tax-free at the time of retirement- if you do a premature withdrawal on your earnings on your Roth IRA- you will be hit with a 10% penalty.
Roth IRA in simple terms- A retirement account you fund just like a savings (taxed money) but is used to buy and sell investments. You will not be taxed on any of your contributions when you withdraw the money and will not be taxed on any earnings when is withdrawn after the age of 59 and 1/2.
PROs of a ROTH IRA
- Funded with after-tax money
- Withdrawals on your contributions can be done tax-free and penalty-free
- Earnings accrue on a tax-deferred basis and are tax-free upon retirement
- Open individually with a brokerage
CONs of a ROTH IRA
- Distribution limit for 2019 & 2020 is $6,000
- Account must be open and funded for at least 5 years in order to avoid any additional penalties
- There are income limits (Modified Adjusted Gross Income (MAGI) must be less than $137k for 2019 if filling single. Less than $203k if married)
The best thing about Roth IRAs is that they are meant to help you invest for retirement but also help you with taxes- here's why. If you know you are in a lower tax bracket right now, the best thing to do is invest with after-tax money (because you are already paying the taxes) and let your money grow in the market, once you retire and take the money out of a Roth IRA there are no taxes to pay no matter the tax bracket you're in at that moment. Meaning, all the money you take out- it's yours, baby!
HSA
Health Savings Account is a tax-free savings account that is funded with pre-tax money and can be used at any time for any medical-related expenses (co-pays, medical bills, pharmacy, clinics, etc). The money on an HSA can be rollover over the years and use for medical expenses during retirement tax-free. An HSA is available when you choose a high deductible health plan.
Another benefit of an HSA is that since the money is tax-free and tax-deferred you are also able to invest this money in the market and pay for your medical expenses out of pocket (if you choose). The annual limit for an HSA for 2020 is $3,550.00 ($3,500 for 2019).
BROKERAGE ACCOUNTS
A Brokerage account is a taxable investment account- you contribute to a brokerage account with after-tax money BUT you're taxed on any earnings (dividends, capital gains, interest). Brokerage accounts are opened through a broker or investment advisory firm. You are able to purchase stocks, mutual funds, Index Funds, and other investment types with this account.
PROs of a BROKERAGE ACCOUNT
- More flexible than a 401(k), IRA, Roth IRA
- No contributions limitations- you can contribute as much as you want
- No income limitations
- Can withdraw your money at any time without penalties
CONs of a BROKERAGE ACCOUNT
- Not a tax-deferred account
- You're taxed on any investment earnings- dividends, gains from buying/selling
- Fees from the firms can be extremely high- choose your broker/advisory firm wisely
OTHER RETIREMENT ACCOUNTS
- Defined Benefit Pension Plan (Pensions Plans)- Pension plans provide a specific payment amount in retirement. The amount is based on factors such as your salary and the years of service. With pension plans, employees have little control over the funds until they are received upon retirement.
- 403(b) Plan- Retirement Account for certain employees of public schools and tax-exempt organizations.
- 457 Plans- Tax-deferred compensation retirement plan/s offered by state/local government and some nonprofit employers. Two types of 457 plan- 457(b) & 457(f).
- SIMPLE Plan / SIMPLE IRA (Savings Incentive Match for Employees)- Sponsored retirement plan offered within small businesses that have 100 or fewer employees.
- SEP Plan / SEP IRA (Simplified Employee Pension Plan/ IRA Plan)- A retirement account that allows you to contribute a portion of your income if you're self-employed and have no employees.
- Solo 401(k)- Best for business owners or self-employed person with no employees except a spouse.
LESS COMMON RETIREMENT ACCOUNTS
- 401(a)
- 419(e)
- 414(h)
- VEBA (Voluntary Employees Beneficiary Associations)
- SERP (Supplemental Executive Retirement Plans)
Now, just because I mentioned all of these different types of retirement accounts does not mean you need to run and try to open one of each- NOPE. The number one thing you should walk away with is knowing that you have options, understanding each of your options and the benefits of each of them.
Next, you will identify what you currently have and where you stand with them (are you maxing them out, are you contributing to them? etc).
Keep in mind, before you open, buy, or sell anything- make sure you're understanding what you're doing. Not understanding could cost you thousands of dollars, and understanding which retirement account is best for you and how they work will save you thousands of dollars.
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