The burden of paying for retirement falls on employees, requiring you to pay more attention to the upcoming costs that must be covered when you stop working. Pensions are becoming less common and social security was never meant to maintain your standard of living. One of the most effective ways to set aside funds for retirement is to take advantage of accounts established specifically for that purpose and come with tax benefits to help your money grow faster.
Whether retirement is a long way off or just around the corner, utilizing tax benefits, and setting aside a little more every year can help you live more comfortably when retirement arrives.
- Work Accounts. 401Ks, 403Bs, and 457s through employers are the most well-known accounts used to pay for retirement. Some companies auto-enroll new employees into an account where others require you to sign up for the benefit. 401Ks often feature an employer match where your employer will put in a certain amount in your account to ‘match’ your contribution. Some companies offer a dollar for dollar match while others give a percentage. Either way, you gain access to ‘free money’ if you contribute at least enough to maximize the employer match. Once you begin, slowly increase your contribution percentage each year. Deductions automatically come out of your paycheck using pre-tax dollars. This reduces taxable income and builds your retirement account faster. Contributions are capped at $18,000 per year with those over 50 able to contribute $6,000 more for a total of $24,000.
- Individual Retirement Accounts or IRAs are available to nearly everyone. Even if you contribute to a work account you likely still qualify for an IRA. Non-working spouses can open a spousal IRA and even teenagers can begin accounts as long as they have earned income. The limits are much lower and cap out at $5,500 with a catch-up contribution of $6,500 for those over 50. Additions may be made to these accounts up until the tax deadline.
- Self Employed and Small Businesses have tax preferred accounts available that are simpler to operate and less expensive than 401Ks. These include primarily the SEP, SIMPLE, Solo 401ks, and defined benefit They are available to sole proprietors as well as companies with a limited number of employees that are not large enough to incorporate a traditional 401K. Small business options offer higher contributions limits than individual accounts and are closer to 401K maximums, but vary by account and income.
- Tax Benefits. Retirement accounts come in two types: Tax Deferred or Tax Free.
- Tax deferred accounts make contributions with pre-tax dollars and give you an immediate tax benefit, in the form of lower taxable income. The money also grows tax free and all taxes are paid as ordinary income when the funds are withdrawn. Most employer accounts such as 401Ks are tax deferred accounts. Traditional IRAs also fall into this category.
- Tax free accounts do not offer any initial tax deduction but the account grows tax free, meaning you never pay taxes on the account growth as long as you leave it in the account until retirement. This is the newest retirement option and is growing in popularity so much so, that some 401Ks are now available as Roth accounts. 529 college accounts and HSA (Healthcare Savings Accounts) also have the benefits of tax free growth, rather than an initial tax write off.
- Understand All The IRS Rules. As with most government benefits, the rules must be strictly adhered to in order to gain the benefit. Retirement accounts that receive preferred tax treatment are also subject to strict IRS rules. There are contribution limits, income limits and withdrawal restrictions and requirements for each account type. Once the money has been earmarked for retirement, a basic universal rule is that you cannot make withdrawals before 59 ½ without being subject to a tax penalty of 10%. There are only 11 exceptions that will waive the 10% withdrawal fee, and funds from tax deferred accounts will also pay taxes when funds are withdrawn. Mandatory withdrawals are required for Traditional IRA accounts at age 70 ½ and penalties as high as 50% can be charged if requirements are not met.
- Age Limits Are Only On the Upper End and Only Apply to Tax Deferred Accounts. 401Ks are the exception and can accept contributions at any age as long as you are still with the company. When you retire, the rules for other tax deferred accounts, apply. The key requirement for contributions is earned income from a job. Investment or passive income does not count. The only exception to this is a spousal IRA which uses the working spouse’s income to qualify. Even teenagers can start an IRA and make contributions. Parents and grandparents can make contributions on behalf of the child, as long as they do not exceed the child’s income. Roth IRAs do not have any age restrictions at the front or back end, where Traditional IRAs only accept contributions to the age of 70 1/2 when required mandatory distributions or RMDs must begin.
- Income Restrictions are a common parameter that must be reviewed. Everyone can contribute to a traditional IRA but the deductibility can be eliminated at higher income levels if you have access to an employer plan. Roth IRAs also have income limits based on filing status and the maximum contribution begins to decline for those earning $184,000 or more if you are married filing jointly. You may contribute to both a Traditional and/or a Roth account but you cannot exceed the maximum limits for all IRA accounts combined.
- Higher Fees and Fewer Investment Choices are the biggest drawbacks to employer accounts. Generally, employees may choose from an average of 19 mutual funds to build a well-balanced IRA accounts allow a much wider range of investment choices. Employer accounts also typically have much higher fees because of the additional administration required for account management. A change in employment gives you the opportunity to roll over your work account into an individual IRA to take advantage of lower fees and more choices. A direct transfer to an individual brokerage account is a tax free transaction. When you choose to receive a check, you have a 60-day window to redeposit the funds without it being considered a withdrawal.
- IRAs Have Many Investment Options. The investment choices are only limited by the custodial you choose. Traditional investment companies like a brokerage house offer a wide selection of stocks, bonds, and mutual funds. For alternative investments like tax liens or real estate you can choose a self-directed IRA and there are very few limitations to your investment choices. These accounts require a more hands on approach to investing but can provide higher returns if managed properly.
- Roth Account Flexibility. A Roth Ira is the only account that allows pre retirement withdrawals penalty free. Because the account does not offer an initial tax benefit you may be able to withdraw contributions without tax consequences. Gains will incur a 10% penalty if withdrawn prior to 59 ½.
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