Understanding the different types of retirement accounts available can help you determine which type you’d like to use to invest for your future. Many people who work for employers use group retirement accounts, especially those whose employers match the contributions they make. However, your employer-sponsored plan is not the only option available to you when it comes to preparing for your retirement.
What Is a Retirement Account?
A retirement account is a tax-advantaged account that allows an individual to save money for when they retire. After retiring from your career, you will need to have a supply of money that will cover your expenses when you are no longer receiving a paycheck. For many people, the costs associated with daily living go up during retirement, such as for those who need more medical care or to live in a facility where nursing staff can assist with certain tasks.
When you plan ahead for this period in your life, you can protect yourself and prevent your loved ones from having to shoulder the financial burden for your expenses. One of the best ways to prepare for retirement is to have at least one retirement account to which you are regularly contributing. A financial advisor can help you determine how much you should have saved up by the time you retire, which will give you an idea of how much to save. Starting early is a benefit since it gives you more time to save additional funds.
As you consider how you want to plan for your retirement, review the various types of accounts available to decide which will offer the most benefits and align with your financial strategy and goals.
- Retirement accounts are designed to help people save money to use when they retire and no longer receive a regular income.
- The main types of retirement accounts include:
- Individual retirement accounts or arrangements (IRA)
- Roth IRA
- SIMPLE IRA
- SEP Plan
- You must follow the regulations and restrictions for the type of retirement account you choose to maintain eligibility.
- By contributing to a retirement account, you can enjoy the tax benefits that come with this savings strategy.
Individual Retirement Account (IRA)
An individual retirement account or arrangement (IRA) is an investment account that you can contribute to on a pre-tax basis. The funds in the account can be used to invest in ETFs, stocks, mutual funds, bonds, and other types of investments after you’ve placed them in it. Some people choose to set up their own personal IRAs when their employers don’t offer retirement account options, while others have IRAs in addition to their 401(k)s. Since a 401(k) has an annual contribution limit, you may choose to have both if you want to contribute more than that amount in a year.
An IRA has a limit as well. In 2019, the limit was $6,000 for those aged 49 and under and $7,000 for those aged 50 and over. Any gains received from your investments are not taxed, which helps them grow quickly. You can also reinvest the gains you receive. If you don’t have a 401(k) in addition to an IRA, you can deduct any contributions made to the IRA on your taxes. Doing so helps reduce the amount of taxable income you have in a year, although restrictions do apply based on your income.
Taking the money out of your IRA before you retire or reach the age of 59 ½ will result in a penalty. You will also have to pay all applicable federal and state taxes on the funds you withdraw. As long as you buy and sell investments within your IRA, and do not withdraw the funds, you can continue to build the amount in this account and increase how much you have available during retirement.
A Roth IRA differs from a traditional IRA in that all contributions are done post-tax. It offers more flexibility for those who may want to take the funds out of the account before reaching the required age for retirement since the money placed in a Roth IRA will never be taxed again, as long as you meet the requirements. In order to avoid a penalty, you must wait at least five years after making your first contribution to withdraw any funds from the account.
Many other retirement accounts require you to start taking withdrawals or distributions when you reach the age of 70 ½, even if you don’t necessarily need the money at that time. This is another way that a Roth IRA differs from other retirement account options. You can keep the money in the account when you reach that age milestone, allowing it to continue to grow. You may choose to set up a Roth IRA if you’re starting out in your career and expect your income to increase during the years before retirement.
If you have a Roth IRA and a traditional IRA, you can contribute to both as long as you don’t exceed the maximum amount between the two for the year. In 2019, the maximum contribution to an IRA was $6,000.
If your workplace offers a retirement account option, it’s most likely a 401(k). This type of retirement account is provided as a benefit to employees, allowing them to contribute a portion of their paychecks to a retirement account. Some employers match the contributions made by employees up to a certain percentage.
In some cases, an employer may require employees to work for the company for a certain period of time before the funds belong to them. For example, if your workplace has a 12-month vesting period, you wouldn’t be able to receive any matched contributions if you left the company before that period was up.
When you contribute to a 401(k), the funds come out of your paycheck on a pre-tax basis. You will continue to be able to contribute until you retire, at which point you can use the funds. As long as you meet the requirements for using the money in your account, you will be able to do so without being taxed. If you withdraw the money in your 401(k) before retiring or before you reach the age of 59 ½, you will be subject to federal and state taxes on the funds, as well as a penalty of up to 10%.
The maximum annual contribution to a 401(k) in 2019 was $19,000, which marked a $500 increase over the limit in 2018. Those who are 50 years or older can contribute up to $25,000 in a year.
A 403(b) account is basically the same as a 401(k), except it’s only for employees of public education institutions, nonprofit organizations, and hospital organizations. The same rules and regulations apply in terms of contribution limits and taxation. If your employer offers a 403(b) and provides a match for any funds you contribute, you should take advantage of the free money.
A 457(b) retirement account is also similar to a 401(k), although it’s offered to local and state government employees. Those who are eligible for this type of plan include police officers, employees across the various departments within the government, firefighters, and other civil servants. Some unions, charities, and hospitals also provide 457(b) plans to their employees.
One of the key differences between a 457(b) and a 401(k) plan is the option to withdraw your funds without being penalized. A 457(b) account is appealing to those who may need to take some or all of the money prior to reaching the age of 59 ½.
A SIMPLE (Savings Incentive Match for Employees) IRA is an option available to those who work for small businesses with 100 employees or fewer. This type of account is set up similarly to a 401(k), although the penalty is stricter. If you take the funds out of the account before you are 59 ½ years old or within two years of setting up the plan, you will have to pay a 25% penalty. Funds also cannot be borrowed from a SIMPLE IRA the way they can be from a 401(k).
A SEP Plan or SEP IRA is designed for people who are self-employed. SEP stands for Simplified Employee Pension. You can use this account to contribute a portion of your earnings to a personal retirement account as long as your small business has no other employees. All deductions made to a SEP plan are tax-deductible. You can also contribute more to this type of account, as the 2019 limit was $56,000 or 25% of your income, whichever is less.
Your retirement savings strategy is an important thing to consider, regardless of whether you’re just starting out in your career or nearing the age when you will likely start to think about retirement. These retirement plans allow you to save money for retirement while determining how much risk you want to take on during the process. Learn more about investing in your retirement account by downloading our free e-book or setting up a one-on-one session with one of our investment experts at Raging Bull.