Which Type of Retirement Account?
Since millions of Americans are currently changing jobs, we thought it would be a good time to review the various types of retirement plans. As you switch careers, you should understand your options and determine which one fits your situation. Even if you are not making an employment change, you should still evaluate your current standing.
Saving for retirement is an imperative part of your financial future. The most common fear that retirees hold is running out of money before time. As much as we look forward to retirement, we also fear it.
You may ask yourself: have I planned or saved enough? Having the proper type of retirement account can go a long way in helping alleviate your qualms.
Employer-Sponsored Retirement Accounts
Not all employers offer retirement accounts, but the number is higher than you may have guessed.
“Retirement benefits were available to 91 percent of state and local government workers. Seventy-seven percent of private industry workers had access to and participated in employer-provided retirement benefits, referred to as the take-up rate. Retirement benefits were available to 31 percent of workers in the lowest 10th percent wage category and 88 percent of workers in the highest 10th percent wage category.”
For many people, a 401(k) is their first foray into retirement investing. A 401(k) allows you to invest pre-tax money, usually in a mutual fund or ETF (exchange-traded fund). The money you contribute goes in tax-free. When you withdraw it after age 59 ½, you pay taxes. The advantage of this is two-fold. First, this can reduce your taxable income for the year you contribute. Second, when you withdraw the money it will be taxed as ordinary income. Most people will be in a lower tax bracket in retirement compared to their working years.
Some employers offer matching funds. If your employer is one of them, be sure to contribute enough to get the match. You would not want to turn down free money. What happens to a 401(k) if you leave your job? Generally, you will have 4 options and can engage in a combination of these options with each choice offering advantages and disadvantages”:
- Leave it where it is (if permitted)
- Cash it out
- Move it to your new employer’s 401(k) plan (if one is available and rollovers are permitted)
- Move the money to a self-directed retirement account, called a rollover IRA
Leaving the money in the current plan can draw additional fees, as the plan is now being managed for someone who is no longer an employee. Given that the average person will change jobs a dozen times throughout their life, keeping track of several 401(k) accounts is hectic.
Cashing out your money before age 59 ½ will mean paying federal income tax. State and local taxes might also apply. Additionally, you will be charged a 10% early withdrawal penalty.
You should join your new employer’s program if the investment choices are attractive. If not, you could perform an IRA rollover, which gives you total control of your investment choices.
For 2020, the contribution limit for a 401(k) is $19,500. The catch-up contribution (allowed for those 50 and older) is an additional $6,500.
A 403(b) plan is very similar to a 401(k). Money is contributed pre-tax and the employer may offer matching funds. The main difference is that these plans are for government or non-profit employees.
For 2020, the contribution limit for a 403(b) is $19,500 and the catch-up contribution (allowed for those 50 and older) is an additional $6,500.
Individual Retirement Accounts
If your employer does not offer a 401(k) or you have reached the maximum contribution limit for the year, an IRA is another option.
A Traditional IRA is similar to a 401(k). Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax. You can open an IRA at a brokerage or any other institution that offers them. You can choose your own investments.
For 2020, the contribution limits for an IRA, Traditional or Roth is $6,000 and the catch-up contribution (allowed for those 50 and older) is an additional $1,000. Those limits apply across all IRAs. You cannot contribute the max to a Traditional and then open a Roth.
A Roth IRA works similar to a Traditional IRA does with one important difference: taxes. A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
You are likely in a higher tax bracket during your working years. Being aware of this can make planning for retirement a bit simpler. We discussed the contribution limits above.
Retirement Accounts for the Self-Employed
Those who are self-employed are eligible to open IRAs, but there are also retirement accounts specifically for them. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
A solo 401(k) is open to a business owner with no employees. The plan can be used to cover you and your spouse. You can choose your tax advantage by choosing the type of solo 401(k) you prefer.
The Traditional solo 401(k) uses pre-tax money. This means your taxable income is reduced for the year you make the contribution. The withdraws are taxed as ordinary income when you take them after age 59 ½.
The Roth solo 401(k) does not provide an upfront tax break but allows for tax-free distributions after age 59 ½. You can open a solo 401(k) account with a broker, and you will be able to choose your investments.
For 2020, the contribution limit for a solo 401(k) is $57,000 and the catch-up contribution (allowed for those 50 and older) is an additional $6,500.
Simple IRA stands for Savings Incentive Match Plan for Employees Individual Retirement Account. It is similar to a Traditional IRA. They are good for small business owners who have employees. Employees can contribute as they would to a 401(k). Employers can contribute to their employee’s accounts by either matching the employee’s contribution or making a non-elective contribution.
For 2020, the contribution limit for a Simple IRA is $13,500 and the catch-up contribution (allowed for those 50 and older) is an additional $3,000.
A SEP IRA is a Simplified Employee Pension IRA. It works much like a Traditional IRA. SEP IRAs are better for those who are self-employed or small business owners with few employees. If you have employees that the IRS considers eligible to participate, you must contribute to their plan. The amount must be an equal percentage of what you contribute to your own.
The contribution limit for 2020 is $57,000 or 25% of compensation, whichever is less.
Which Retirement Account is Right for You?
Your employment situation will determine what kind of retirement account you will manage. If you do not have access to a workplace plan, you can choose between a Roth and a Traditional IRA. Your CFP® can help you decide which plan suits you best. If you have access to an employer-sponsored plan and do not like the investment options, you may wish to open an IRA. Even if the options in your employer-sponsored plan are not ideal, if they offer a match, you should consider it.
For those who are self-employed, you have several options. When choosing, consider the tax implications, how many employees you have, and how much you want to contribute. And as always, we at Paradigm Wealth Partners are here to help you make these important decisions.
Information in this material is for general information only and not intended as investment, tax or legal advice. Please consult the appropriate professionals for specific information regarding your individual situation prior to making any financial decision.