Today’s post will be focused around tax-advantaged accounts in the United States. Your primary options are going to be 401(k)s and IRAs. There are some other products such as HSAs, 403(b)s, 457s, TSPs and ESAs. Most of the aforementioned products have unique situations in which they are your retirement vehicle. 401(k)s and IRAs are the bread and butter of retirement savings. They are powerful tools that when used correctly can propel your retirement savings into the stratosphere.
A 401(k) is an employer sponsored retirement program. This is one of the most common retirement accounts in America. 401(k)s are defined-contribution accounts that employees contribute to generally with some match from their employer. These contributions are taken from a payroll withholding. The earnings from these 401(k)s are taken during retirement age, defined by the IRS as after 59 1/2, in order to avoid the penalty of 10% for early withdrawals. There are some caveats to this rule which we will cover later.
The benefit of 401(k)s is that they are a tax advantaged account. There are two main types of 401(k)s, traditional (often just referred to as a 401(k)) and Roth 401(k)s. The difference between the two is how the money is put in and taken out of these accounts.
Traditional accounts are tax-deferred. This means that you do not pay any income tax on your contributions. Instead you pay tax on the withdrawals as ordinary income in retirement. This is beneficial to those who believe they are currently being taxed at a higher rate than they will in the future. This hold true for most people who have been in their career for at least a few years. The downside is that your gains are also being taxed at ordinary income rates. Given that the market has roughly a 7% inflation adjusted annual return your money will be doubling roughly every 10 years. The longer you are invested in this traditional account the more money you have subject to taxation.
Roth 401(k)s on the other are tax-exempt accounts. That means that you pay taxes on the money that you deposit now in order to withdraw the money tax free in retirement. This can be extremely beneficial for younger investors who have plenty of time to let the money grow. If you are investing with at least a 30 year time frame you have 3 chances for the money you are putting into double. I’d much rather pay tax now then on eight times that amount!
Roth 401(k)s also have the requirement that the account is held for at least 5 years to make the distributions qualified.
Other Types of 401(k)s
There are three other types of 401(k)s that are worth mentioning. These are Safe Harbor 401(k)s, Simple 401(k)s and Solo 401(k)s. Each of these have their own unique caveats.
Safe Harbor 401(k)s have the requirement that employers must either contribute 3% of employee wages or match contributions of 3% plus an additional 50% of the employees contribution up to 5%. They also do not have nondiscrimination test requirements
SIMPLE 401(k)s are for business that have 100 or fewer employees. They must match either up to 3% or contribute up to 2% of every employees wages. They also have lower contribution limits than other 401(k)s
Solo 401(k)s are for business with no employees. They are limited to 25% of the total compensation from the business that is passed through to the sponsor.
401(k) Contribution Limits
As of 2020 the contribution limit for most 401(k)s is $19,500. There is a catch up contribution limit for those who are older than 50 of $6,500 bringing their total contribution limit to $26,000. The only difference is SIMPLE 401(k)s which have an annual contribution limit of $13,500.
IRAs are tax-advantaged retirement accounts that are generally initiated by an individual. The two main types of IRAs are Traditional and Roth. The main difference between 401(k)s and IRAs are the contribution limits. IRAs have the same requirement that you can not withdraw from them until you are 59 1/2 with a few caveats. One of the largest benefits of IRAs is that you aren’t limited by the sponsor’s investment choices for the plan.
Traditional IRAs are treated in the same manner as Traditional 401(k)s. They are tax-deferred accounts as long as you meat certain qualifications. I will be listing the requirements if you are covered by a retirement plan at work. For those filing single or head of household and your AGI is $65,000 or less you get a full deduction. Greater than $75,000 you do not get a deduction. Anywhere in between you get a partial deduction. For married filing jointly or qualifying widowers these numbers are $104,000 and $124,000 respectively. For married filing separately, you only get a partial deduction if your AGI is less than $10,000. Don’t ask me on that last one.
This can be a great way to shelter more money if you are already maxing out your 401(k). Or if you do not like the options that your 401(k) provides you can contribute enough to get the match and then switch to the IRA.
Roth IRAs, as you can imagine, work very similar to Roth 401(k)s. They are also tax-exempt accounts that give you the benefit of allowing your account to grow tax-free. Roth IRAs work a little different than Traditional IRAs in that they Income Limits contribute rather than take the tax deduction. These are as follows, $196,000 for married filing jointly or qualifying widowers, $10,000 for married filing separately and $124,000 for single or head of household.
Roth IRAs also have some other interesting benefits. You are able to withdraw up $10,000 to pay for a first-time home purchase penalty free. You can also withdraw contributions tax and penalty free at any time. Not that I am recommending dipping into your retirement accounts, but it is worth noting.
Other Types of IRAs
There are a few other types of IRAs including SEP IRAs, spousal IRAs, SIMPLE IRAs and self-directed IRAs. Each one of these have their special use cases and why we would need them.
SEP IRAs are technically simplified employee pensions. Even though it is an IRA it is very similar to a 401(k) They are probably closest to a solo 401(k) an employer may choose this option if they would like to avoid the startup and operating costs of traditional retirement plans.
Spousal IRAs are for couples who only have one working partner. The other partner can still set up a retirement account under a spousal IRA. The main requirement is that you file a joint tax return.
SIMPLE IRAs are very similar to SIMPLE 401(k)s. Rather than getting into the nitty gritty of it, I will direct you to this great Investopedia article.
Self-directed IRAs are probably one of the most under utilized wealth generating tools. They allow you to hold assets such as real estate, precious metals or even privately held companies that a normal retirement vehicle does not. Might be time to use your IRA money to renovate that bedroom in your rental.
IRA Contribution Limits
As of 2020 the contribution limit for most 401(k)s is $6,000. There is a catch up contribution limit for those who are older than 50 of $1,000 bringing their total contribution limit to $7,00. The only difference is SIMPLE and SEP IRAs which have an annual contribution limit of $13,500 and $57,000 respectively.
401(k)s and IRAs In Conclusion
Tax advantaged accounts can be tricky. Hopefully that clears up some of the different situations in which you would want to contribute to either a 401(k) or an IRA. There are other tax-advantaged accounts that were mentioned previously which are available for unique circumstances. The best thing you can do is to consult your tax professional regarding your situation. Let the professionals do the heavy lifting.
Do you use any of these tax advantaged accounts? Let us know in the comments below!
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