Retirement planning can set you up for a financially free future. There are many types of retirement accounts with various benefits. In this article we will cover what these retirement plans are and how they can potentially help you secure a more financially free future.
401(k) plan
Contributions to a 401(k) plan are made pretax and taxes are taken out once distributed. Most employees are familiar with this plan because often offered through employment and usually includes employer matching funds. It is beneficial for employees to take full advantage of their 401(k) employer match. For example, if your employer matches your contributions up to 3% of your income and you make $50,000 a year, your employer will match your contributions up to $1,500 a year.
However, your employer will only match your contributions. This means that if you don’t contribute at least 3% of your income, you may not receive the total employee match amount. This is why most individuals contribute at least enough to fully optimize their employer match. It’s also important to note that most employer matching require a vesting period. This means that your employer match will only be yours after a certain amount of time with your employer. For example, some employers may say that 20% of your employer match amount will be fully vested (available to you) after two years with the company, 40% will be available after 3 years, 60% will be available after 5 years, and 100% will be available to you after 10 years. This is important to keep in mind if you only plan on staying with a company for a limited amount of time.
Employees can contribute up to $19,500 to their 401(k) plan for 2020 and 2021. Anyone age 50 or over is eligible for an additional catch-up contribution of $6,500. A 403(b) plan is similar to a 401(k) but is for individuals who work for a nonprofit or tax-exempt organization.
Individual Retirement Account (IRA)
An IRA is a retirement account that is similar to a 401(k) but is not employer sponsored. You generally can establish an IRA with a brokerage firm (Fidelity, Charles Schwab, Vanguard, etc.) and individuals can still participate in an IRA even if they are part of an employer sponsored 401(k) plan. The contribution limit for an IRA is $6,000 in 2021 ($7,000 if you are 50 or older). Like a 401(k), you’ll receive a tax deduction for the money you put into an IRA (contributions are considered pretax). When you withdraw funds, they will be taxable income. There are several types of IRA accounts.
Roth IRA
Contributions to a Roth IRA are made after-tax and no taxes are taken out once distributed. The main benefit of a Roth IRA is that earnings are nontaxable. For example, let’s say you contribute $200,000 to your retirement over the course of your 30-year career and by the time you retire your retirement account is worth $2,000,000. If you contributed this money to a Roth IRA, then the $200,000 in contributions would have been made after-tax. However, the $1.8M in earnings ($2M-$200K) will be distributed tax free! On the other hand, if you had contributed $200,000 to a 401(k) over the course of your career, the entire $2M retirement account will be taxed when you start receiving retirement distributions.
However, a Roth IRA does not provide you with the same employer matching benefits and you can only contribute up to $6,000 a year to a Roth IRA account (or $7,000 if you’re 50 or older). In addition, you’re eligibility to contribute to a Roth IRA is based on your income level. If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be under $139,000 for the tax year 2020 to contribute to a Roth IRA. If you’re married and file jointly, your MAGI must be under $206,000 for the tax year 2020.
Self-Directed IRA
The main difference between a traditional IRA and a self-directed IRA is that a self-directed IRA allows you to place funds into alternative assets such as precious metals, cryptocurrencies, and real estate.
Simplified Employee Pension IRA (SEP IRA)
An SEP IRA is ideal for self-employed individuals or small business owners with no or few employees. With an SEP IRA you’ll be able to contribute up to 25% or $58,000 in 2021 (whichever is less). Similar to a traditional IRA, you won’t pay taxes on amounts contributed but distributions will be taxed. However, employers must contribute an equal percentage of salary to each eligible employee. So, if an owner gets a certain percentage match then all employees must receive the same.
