Some of us dream about the day we get to retire. All of those long, hard years of labor, you can finally hang up the laces for good and life will be wonderful, right? A lot of individuals do not plan financially for that day. You should start planning for retirement right away, in fact, as soon as you begin to make earned income, some of that income should be contributed to a retirement account. Deciding which type of IRA to open is always a challenging decision as we never know what the future holds.
Both 401(k)s and IRAs have tax benefits for you, and the good news is: you can contribute to both at the same time. Often employers will offer 401(k)s, which allow higher annual contributions, and individuals open IRAs, which may offer more investments.
A 401(k) plan is a retirement account with tax advantages and many employers’ defined contributions. It gets its name from the section of the U.S. Internal Revenue Code. Employees make contributions by withholding from their paycheck, and the employer can match some or all the amount contributed. There are five types of 401(k) plans:
- Traditional 401(k) plans are tax-free until the employee withdraws the money.
- Roth 401(k) plans are included in taxable income, but tax-free when withdrawn.
- Safe Harbor, which is the same as traditional, except the employer avoids the time and money involved in performing the nondiscrimination tests required for traditional.
- SIMPLE is similar to the Safe Harbor, but employers’ contributions are nonforfeitable as soon as they are contributed. Only for business with < 100 employees.
- Solo is just that, meant for the owner of a business with no employees—same rules as the Safe Harbor in the fact you do not need to conduct annual nondiscrimination testing.
An IRA (individual retirement account) allows individuals to invest in pre-taxed income. The IRS calculates no capital gain or dividend income until the beneficiary makes a withdrawal. Individual taxpayers can contribute all their earned income up to a defined maximum dollar amount. The two main plans are again Traditional and Roth, but there are other attractive options.
- Traditional IRA is the most popular because of its upfront tax break of up to $6,000 plus an additional $1,000 catch-up contribution if you are over 50 years old. This is best for individuals who are in a high tax bracket if they think they’ll be in a lower tax bracket when they retire because withdrawals are taxed at the tax rate at the time they’re withdrawn
- Roth IRA is just the opposite, great for individuals who see themselves in a higher tax bracket when they retire since there is no tax on withdrawals from a Roth IRA. It’s also a better choice if the individual might need to access some of the money before retirement.
- SEP (simplified employee pension) IRA is best for small-business owners who want to avoid the costs of maintaining a conventional retirement plan. They also get a tax deduction for any contributions made for their employees.
- Nondeductible IRA are for those who don’t qualify for a Roth or deductible IRA because their income exceeds the IRA income limits. Contributions still get the perk of deferring the tax for the growth on earnings. The growth will be taxed when taken out, but not the principle since it was funded with dollars that were already taxed.
- Spousal IRA is for couples who file a joint tax return. Typically for low-income or individuals who are not working married to someone who has earned income.
- SIMPLE (Savings Incentive Match Plan for Employees) IRA is for companies with fewer than 100 employees. Unlike most sponsored plans, contributors can roll the money into a traditional IRA after two years.
- Self-directed IRA is for experienced investors who want alternative investments, including real estate and nontraditional businesses. Setting one up requires a trustee or custodian who specializes in the types of investments.
There are several types of 401(k)s and IRAs to choose from, it’s important to do the research into which works best for each individual and employer.
Which is the best option for you?
- First, look at your tax bracket and see where you fall. Since there are income limits for Roth IRAs, if you make too much money as a taxpayer, then a traditional IRA is the right choice
- Second, consider where you believe your tax rate will be when you reach retirement age. Although income tax rates do change, think about if you will remain in the lower tax bracket. If that is the case, you will more than likely want to choose a traditional IRA since you can get a tax benefit now, then be taxed at lower rates
A Roth IRA is an individual retirement savings account that allows you to pay taxes on the money you put into it up front. Any withdrawals after the age of 59 ½ are tax-free. This is extremely helpful for those individuals who expect to be in a high tax bracket once retirement is reached. Unlike a traditional IRA, you are not required to take distributions at a certain age. You can also continue to contribute to a Roth if you choose to work past retirement age, as long as your income still falls within the income limits. Another perk to having a Roth IRA is that it can provide some quick cash in a pinch. Roth contributions can be withdrawn penalty-free at any time (remember that earnings withdrawals are subject to a 10% penalty).
A traditional IRA is a type of individual retirement account in which individuals can make pre-tax contributions and the investments in the account grow tax-deferred. The contribution limits for 2020 and 2021 (for single filers) is $6000 annually. Early withdraws from an IRA account will increase your taxable income and you will be assessed a 10% penalty. For a traditional IRA, you must make required minimum distributions (RMDs) at age 70.5.
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