Understanding Retirement Accounts
With all the different types of retirement accounts, it can be difficult understanding retirement accounts. Retirement can feel like a long way off but that doesn’t mean you shouldn’t be thinking about it and the right retirement account. Before we dive into each type of account, what is a retirement plan account? This is an investing tool that is specifically focused on retirement. These accounts can be pre-tax or tax deferred until the owner retires or reaches a certain age. Then the owner can start to withdraw funds from the account if they choose.
Retirement accounts have a lot of advantages over just a regular investing account. The biggest being when it comes to taxes. In some cases, you can but in money you earn before taxes are taken out. In others, you can withdraw the funds tax free. An additional advantage that comes with retirement accounts is employer contributions. Some companies will give you an additional amount of money for free for putting money in your account. Contributing to these accounts also can reduce the amount of taxes you have to pay now.
Now that we’ve covered a little bit about these, let’s dive into each of the most common retirement account options. Then we’ll get into investment strategies for them.
Types of Accounts
These are the most common type of retirement accounts provided by employers. These accounts are a great way to start preparing for retirement. When you start working for a company they give you the option to start taking a percentage of your paycheck to contribute. Some employers will also contribute money into your account if you put some in. These are called match contributions. For example, if you donate 3% of your annual salary, your company may also contribute 3% as well into your account. This is why it’s in your best interest to contribute the max amount of the match to get the best deal you can. It’s essentially free money!
Contributing to your account also can reduce your income for this year. Which means you can reduce how much you pay for taxes this year. While there are limits per year, they are capped at $18,500 per year.
Unlike some retirement accounts, a 401k account has a limited number of investments you can choose from. While we’ll get into this a little later on in this article, these just means you don’t need to be a professional to do well investing within it. The company that holds your retirement account usually has a free line to call for advice with it too. Just to make sure you are getting the most out of your retirement plan. Want to know more about a 401k? check out the below links:
Check out here for the 10 best ways to make the most of your 401k here
Also, what exactly is a 401k? Check it out here
403b retirement accounts are a type of retirement account that operate identically to that of 401ks. They have the same choices for investment options, employer contributions, and contribution limits. You must be wondering then, what is the difference between a 401k and 403b? It will depend on your type of employer.
These types of accounts are for those working at non-profits (e.g. 501c3) organizations, public schools, and health organizations like hospitals. This shouldn’t be confused with government jobs retirement accounts as we’ll cover those next.
If you’re a government employee for a state or local agency, then this is the type of retirement account your employer will provide. This plan will follow a lot of the same rules as a 401k or a 403b. You will be able to defer taxes on these until you draw the funds from the accounts, just the like previous accounts. You’ll also receive a tax deduction for contributing.
There is one big different between a 457 retirement plan and the previous accounts is the contribution limits. While a 457 still has the limit of $18,500 that the others do, some employers offer both a 457 and a 403b. This means that you can contribute to both of these, and that will double the maximum contribution limit. If you have the means, it can be a huge advantage to contribute to both.
Savings Incentive Match Plan for Employees, or a SIMPLE IRA Plan, is most common for people looking to start a retirement plan that isn’t sponsored or provided by their employer. It could also be an additional account to an employer sponsored plan. In other cases where an employer does provide one, it’s usually a smaller company. Usually those with less than a hundred employees use these.
When it comes to those using a SIMPLE IRA from an employer there is a minimum contribution an employer is required to have. It generally is 3% of the annual compensation that the employee receives but ask your employer to confirm. Another perk for the employee is that they are fully vested with the funds. Some companies with 401K plans will require that the employee work for a specific amount of time before they can keep their employer’s contributions. When it comes to a SIMPLE IRA, that is no longer the case.
However, it isn’t all positives when compared to other retirement accounts. The contribution limit is lower than that of the other retirement accounts. While the others have allowed for $18,500 in annual contributions, a SIMPLE IRA contribution limit is $12,500. Another draw back is that you can’t take out a loan against the account if you have a financial hardship. Once you reach the age of seventy and a half years old, you’ll have required minimum distributions. Just like they sound, you are forced to start withdrawing funds. This happens even if you don’t want or need to withdraw any funds.
Unlike other retirement plans that are participant directed investments, or the employee has input on the investments, SIMPLE IRAs have a plan administrator. The difference is that the employee doesn’t have the options of which funds they would like to invest in, these are chosen by the employer. While some might see this as a negative, it can be a positive if you are not comfortable with making the selection yourself.
Let’s cover some Roth IRA basics. A Roth IRA operates differently than any of the previous types of retirement accounts we’ve talked about. All of the previous accounts focus on money that is pre-tax being contributed into your retirement account. This allows you to take the tax deduction now, as oppose to in the future. Roth IRAs are funded with after tax dollars. Which would be money coming from a paycheck after taxes have been taken out.
You might be wondering what the advantage is to this account if the funds are already taxed, and you can’t take a tax deduction now. If you’ve held the account for five years, and you aren’t below the minimum withdrawal age of fifty-nine and half, you can take withdrawals from the account tax free. That means all of the gains you have made in the account from investments will be withdrawn tax free. This can be a huge advantage.
With the advantage of tax free withdrawals there are some draw backs to these accounts. The amount you can contribute annually into these accounts is significantly lower than those of the other mentioned accounts. You can contribute up to $5,500 if you are under the age of fifty to your Roth IRA savings. If you’re fifty or older you can contribute up to $6,500 per year.
This type of account will operate just like a Roth IRA, as it will use after tax dollars. These are through your employer, and you will set aside part of your paycheck after the taxes have been taken out. The good news is that the account will still give tax free withdrawals, just like the Roth IRA.
Retirement accounts vary depending on the specific account, and so can the retirement rules. There are potential penalties you’ll need to keep in mind to avoid so you can make the most of your hard-earned money. Retirement accounts have a minimum age that you can withdraw your funds at, which is fifty-nine and a half.
That being said, if you have an emergency and need the funds there are options. Some accounts will allow loans from the account. If you do withdraw funds early, there will be a 10% fee that you’ll have to pay in addition to taxes owed on the money. This fee is to help deter people from touching the funds too early.
Another penalty you’ll need to keep in mind is the minimum required distribution sometimes called the IRA withdrawal penalty. While we discussed this earlier, it’s important to remember that funds need to be pulled from some accounts by age seventy and a half. The reason this is so important is because the penalty fee is 50%, that’s right, half of your distribution. The last thing you want to do is take half of that money and give it right back to the government.
Before we get into the investment strategies for different retirement accounts it’s important to reiterate participant directed investing versus plan administrator investing. Participant directed means that the employee, or the owner of the account gets to decide where the funds go. Compare this to a plan administrator which decides for you what the investments are.
If you have a participant directed investing retirement account, there are going to be limited number of choices for you to select. This is for 401K, 403b, and 457
accounts. Usually the company holding your retirement account has a customer service group that will help you in det
ail with a professional financial advisor. It doesn’t hurt though to have a good personal understanding.
There are some choices that will have a specific set retirement date/year. These are a great set and forget type of investment. Generally, the younger you are the more risk you can take on in your retirement account. This is because you have until fifty-nine and a half before you can draw on it. It will give you a lot of time to recover from a market crash. By selecting one of these set and forget funds the manager of the fund will then adjust the risk as the retirement date gets closer. If you need a refresher on stocks, bonds, and mutual funds check out our article here.
If you are feeling like you want to try for possibly better returns or want a more specific type of investment allocation in your retirement account you can select your own. There are generally a wide range of options within a retirement account. This can go for the riskiest such as international funds all the way to the most conservative as U.S. Treasury Bonds.
The above mentioned three types of retirement accounts allow for you to select a specific percentage of your income that goes into each of these funds. With this, you can create your own blend of risk. If you want to put it all on the riskiest mutual funds you can. If you want to split 95% domestic stocks, and 5% U.S. Treasury Bonds and adjust the balance between the two as you get older that’s an option too. This will allow you to make changes as you see fit.
While changing between different funds isn’t the best idea because of fees you’ll incur, re-balancing your investments is a good thing to look at. It’s best to check on your retirement accounts every quarter and revisit the investment strategy annually. If you don’t select a mutual fund when you begin funding your account, your company should default you into the most conservative.
Within your Roth IRA you will have a much wider range of investing options. These can be a brokerage account with everything open to invest in. If you’re a novice investor who doesn’t want to check in on this type of account often, looking at ETFs (Exchange Trade Funds) is a great option. Many custodians have a great selection that doesn’t have any commissions or fees to purchase in or out. It also is a great way to avoid minimums that mutual funds have. EFTs operate the same as a mutual fund in that they are made up of different securities. The cost is only the price of a share, instead of the several thousands mutual funds cost up front. You can mirror a strategy similar to the ones for 401K, 403b, and 457.
If you’re a bit more skilled of an investor you can look at buying into stocks and bonds. Working your allocation more towards fixed incomes as you get closer to your retirement date. If you don’t have one, a good suggestion is sixty-five. Picking popular stocks such as Amazon, Google, Wal-Mart, or Berkshire Hathaway Class B stocks can be great consistent moving stocks. Buying and holding these long term is a great way to see your account grow steadily.
In summary, there are many options to start saving money for retirement. Even if you can’t imagine that day ever coming talking with your employer or setting aside a specific amount each month will add up. This will make all the difference as you begin to achieve your retirement goal.