Otterwize

What You Otter Know About Personal Finance

Retirement Accounts

Retirement may seem like a long way off, but time flies when you’re having fun.

Starting to plan for retirement as early as you can is one of the best things you can do for your future self (besides eating your carrots and going for a run). The sooner you start to save and invest for retirement, the less you’ll need to put aside on a monthly basis to reach your financial goals. Fortunately, there are many different tax-advantaged retirement savings options available, including the following:

401(k) plan

  • A 401(k) plan (named for the section of the tax code that covers these plans) is an employer-sponsored retirement savings plan that provides a way for you to save and invest for your retirement on a tax-deferred basis.
  • The money that you invest is pre-tax money, meaning the amount of taxable salary that your employer reports to the IRS is reduced by the amount you contribute to your 401(k) account. The income tax on your contributions is deferred until you take withdrawals when you reach retirement age.
    • You can withdraw earlier but those incur penalties.
  • The money in your 401(k) account compounds on a tax-deferred basis, meaning you don’t pay tax on the earnings until you take withdrawals.
  • The tax you will ultimately pay depends upon your tax rate at the time of withdrawal.
  • If you are lucky enough to have an employer that sponsors a 401(k) plan, you should take advantage of it and participate as soon as you are eligible (unless you have some compelling reason not to).
    • Eligibility terms can vary, so check with your employer. Some employers allow you to participate right away, and others require you to work there for one year before you can enroll.
  • There are annual IRS contribution limits based on age and type of account. For 2020, the 401(k) employee deferral limit is $19,500 with catch-up contributions of $6,500 if you are 50 or older at the end of the calendar year.
    • Your employer can also impose limits on the percentage of your salary you can contribute, even if those limits are lower than the IRS limits.
    • Some employers may also impose a minimum to participate.
  • Many employers will match your contributions dollar-for-dollar or as a percentage of every dollar, up to a certain percentage.
    • It’s important to understand the terms of the match and to try (VERY HARD) to contribute up to the full match amount.
    • If you contribute less than the maximum match percentage, you are leaving “free money” on the table.
  • The number of investment choices offered to employees varies among plans, but many offer around 10 or more. These investment choices mostly consist of mutual funds and ETFs but can include other choices, including company stock. (But see here (item 8) for discussion of investing too heavily in company stock.)
  • For more information on 401(k) plans, see here. See also 10 Things to Think About When Signing Up for a 401(k).

Roth 401(k) plan

  • A Roth 401(k) has some similarities to a Roth IRA, in that the money you contribute is after-tax money, not pre-tax money.
  • The benefit of a Roth 401(k) is that your earnings grow tax-free, so there will be no tax due when you withdraw the money upon reaching retirement age (as long as you are over 59½ year old and you had your account for at least five years). With a traditional 401(k), you pay tax upon distributions when you reach the age of retirement.
  • If your employer offers both types of 401(k) plans, you should decide if you want to pay the tax now on contributions and have earnings grow tax-free (with the Roth) or pay the tax later on contributions and earnings when you withdraw the funds (with the traditional 401(k)).
  • You are allowed to have both a traditional and Roth 401(k) (if both are offered by your employer), as long as your total contribution does not exceed the annual limit.
  • Unlike the Roth IRA, the Roth 401(k) has no income restrictions to participate.
  • For more information and to compare the Roth 401(k) to the traditional 401(k), see here. See also item 10 in 10 Things to Think About When Signing Up for a 401(k).

403(b) plans

Solo 401(k)

  • A solo 401(k) (also called “one-participant 401(k)” or “solo-k”) is for self-employed people with no employees.
  • The rules and requirements for contribution limits, deferral, etc. in a solo 401(k) are the same as with any other 401(k) plan.
  • Solo 401(k) plans allow a self-employed individual (i.e., the business owner) to make contributions to a 401(k) plan as both the employee and the employer.
  • Solo 401(k) plans can be either Roth or traditional.
  • Setting up a Solo 401(k) plan takes a little longer than setting up other self-employed retirement accounts.
  • For more information on solo 401(k) plans see here.

IRA generally

  • An IRA allows you to make tax-advantaged investments for retirement. There are many types of IRAs, but the two main kinds are the traditional IRA and the Roth IRA. (The acronym “IRA” (Individual Retirement Arrangement) is an umbrella term that includes individual retirement accounts or annuities.)
  • IRAs provide a larger range of investment options than most employer-sponsored plans.

Traditional IRA

  • In a traditional IRA, there are no income limits on who can contribute (unlike in a Roth IRA).
  • You can contribute to a traditional IRA if you have taxable compensation, but you can’t contribute in the year you reach 70 1/2 years of age and older. (In a Roth IRA, there are no such age limits.)
  • You can deduct your contributions to your traditional IRA, subject to certain limits if you or your spouse are covered by a retirement plan at work and your income exceeds certain amounts.
  • Your deduction is allowed in full if you and your spouse are not covered by a plan at work.
  • Your total annual contributions to all your traditional and Roth IRAs combined cannot exceed:
    1. $6,000 (or $7,000 if you are 50 years old or older); or
    2. your taxable compensation for the year, if you earned less than those amounts.
  • The deductible contributions and earnings are tax-deferred until you withdraw the funds (i.e., they are taxed when you withdraw the funds).
  • If you withdraw the funds before age 59 1/2, you may have to pay an additional 10% for early withdrawal unless you qualify for an exception.
  • For more information, see here.

Roth IRA

  • You can contribute to a Roth IRA at any age if you have taxable compensation and if your modified adjusted gross income is below certain limits.
    • For 2020, if your modified adjusted gross income is:
      • greater than or equal to $206,000 (married filing jointly) or $139,000 (single), you cannot contribute to a Roth IRA.
      • between $196,000 and $206,000 (married filing jointly) or $124,000 and $139,000 (single), you can contribute a reduced amount.
      • less than $196,000 (married filing jointly) or $124,000 (single), you can contribute up to the annual contribution limit.
  • Roth IRA contributions are not tax-deductible. The flip side is that you get to withdraw the funds tax-free (as long as you meet certain requirements – see below).
  • Your total annual contributions to all your traditional and Roth IRAs combined cannot exceed:
    1. $6,000 (or $7,000 if you are 50 years old or older); or
    2. your taxable compensation for the year, if you earned less than those amounts.
  • Distributions from a Roth IRA are tax-free as long as you meet certain requirements, including that the distribution is from an account that was set up at least 5 years ago, and that you are at least 59 1/2 years old.
  • If you withdraw funds (other than a return of your regular contributions) before age 59 1/2, you may have to pay an additional 10% for early withdrawal unless you qualify for an exception.
  • For more information, see here.

SEP IRA

SIMPLE IRA

  • A SIMPLE (“Savings Incentive Match Plan for Employees”) plan allows employers and employees to contribute to SIMPLE IRAs that are set up for employees.
  • SIMPLE IRA plans are available to any small business with 100 or fewer employees as well as those who are self-employed.
  • The employer must either match employee contributions up to 3% of compensation or contribute 2% for each eligible employee.
  • Employee salary reduction contributions (also called elective deferrals) for 2020 are limited to $13,500 (with an additional $3,000 catch-up contribution for employees age 50 or over).
  • To be eligible, employees (including those who are self-employed) must earn at least $5,000 during any 2 years before the current calendar year and expect to earn at least $5,000 during the current calendar year.
  • Rules for contribution deductions and for distributions are similar to traditional IRA rules.
  • For more information, see here and here.

Health Savings Account (HSA)

  • A Health Savings Account (“HSA”) is a tax-exempt account you set up to cover certain medical expenses.
  • To be eligible, you need to have a high-deductible health plan (HDHP) plus meet other requirements.
  • You can deduct contributions you make to the HSA even if you don’t itemize.
  • Distributions may be tax-free if you use them for qualified medical expenses.
  • Distributions not used for qualified medical expenses before age 65 are charged an additional 20% tax.
  • The reason HSAs are included under Retirement Accounts is that funds in the account (contributions as well as earnings) roll over from year to year if unused. At age 65 or older, you can withdraw funds for any expense without penalty, but any funds used for non-qualifying medical expenses are subject to income tax.