As pensions decline, funding your own retirement has become an essential process during your working years. The sooner you begin, the less actual dollars you must contribute, and the larger your account will grow. While it may seem retirement is a long way off when you first begin working, paying for 20 plus years of retirement is no easy task. Understanding the fundamentals of retirement accounts will enable you to maximize benefits and increase the funds available when retirement comes around.
- Retirement Fund Tax Breaks. Retirement accounts receive preferential tax treatment, which increases the effective rate of return. This can have the effect of increasing account balances because investments are working more efficiently. By saving the 20% capital gains tax on all earnings, that money is left to grow in your account each year, giving you compounded growth. Just as compound interest allows money to grow faster, allowing 100% of your investment to compound will increase balances.
- Tax-deferred versus tax-free. Retirement accounts come in one of two forms. They either grow tax-deferred or tax-free. Tax-deferred accounts such as 401(k)s and Traditional IRAs use pretax dollars to fund the accounts. This strategy reduces taxable income in the year the contribution is made and taxes are paid at the time of withdrawal. Tax-free accounts do not offer tax benefit upfront, however the entire account will grow tax-free. Having a combination in both account types can provide a retirement strategy which reduces taxable income at retirement, while still giving you the benefit of reduced taxable income during your working years.
- Employer Matches. Nearly all large corporations and approximately two-thirds of smaller companies which offer retirement accounts, also have an employer match. This translates to free money to fund your retirement account. Matches can be 25%, 50%, or 100% of your contribution, up to a certain percentage. Employer matches are a good way to increase total contributions and take advantage of tax-deferred growth. If your employer offers a match, it is always best to ensure your own contribution level maximizes the employer match as well.
- Know the Rules. IRS tax preferred accounts come with strings attached. The primary restriction is withdrawals are not allowed without penalty prior to age 59 ½. Early withdrawals will result in taxation at your current tax rate, in addition to a 10% penalty. There are only 11 exceptions that allow withdrawals without a penalty, but are still taxed at your current tax rate. Any early withdrawal will result in fewer funds being available at retirement.
- IRA Accounts Are Not Restricted to Mutual Funds. 401(k)s have greater restrictions because you must choose from the options your employer offers, which is generally a small number of mutual funds. IRAs however, offer a much wider range of investment options. With an IRA, you are able to invest in mutual funds, ETF’s, stocks, bonds, and traditional investment vehicles. They also offer self-directed accounts which open the door to non-traditional investments like real estate, tax liens, and even some forms of lending.
- Age Restrictions on IRAs. There is no limit on IRA contributions on the front end. Children with earned income can start an IRA account. Parents, grandparents, or the child can contribute up to 100% of earnings into an account. On the backend, Roth IRAs do no age limits and the only restriction on withdrawals after the age of 59 ½, is that the account must be in place for at least five years. Traditional IRAs only accept contributions to the age of 70 ½ and minimum withdrawals (RMDs) must begin at that time, based on account balances.
- Roth IRAs Offer the Highest Level of Flexibility. The Roth account is the only retirement account that allows withdraws of the initial contribution with no tax penalty. Because there is no tax benefit upfront, taxes are only due on gains, which must remain in the account until the account owner is 59 ½. They also have an income restriction where contribution limits are phased out.
- 401(k)s Have Higher Expenses and Administration Fees. One of the few downsides to a 401(k) is the high fees that can be charged. An employer match and higher contribution limits make the accounts very valuable. You also have the ability to transfer the account to an IRA if you change employers. As long as the transfer follows the IRS rules, it can be done without any tax consequences.
- Retirement Maximum Contributions. 401(k)s offer the highest contribution limits of $18,000 per year. Participants over the age of 50 can add an additional $6,000 for a maximum contribution of $24,000. IRAs have much smaller maximums of only $5,500 in combined contributions. An additional $1,000 is added for account holders over 50.
- Doubling Up On Contributions. For most workers it is possible to contribute to both a 401(k) and an IRA in the same year. If you own your own business or do taxable freelance work, you may also be able to contribute to a small business IRA account. This can increase maximum limits even further.
- Auto Enrollment should not be relied on for retirement planning. The auto enrollment process used by many companies is meant to increase participation but does not take into account your investment preferences. They typically only take a small percentage of income and invest them in target date funds. This may not be consistent with your investment objectives or risk tolerance. When you manually enroll you can choose from an array of funds based on performance and risk, as well as adjusting the level of contribution. The best strategy is to increase your percentage of contribution at least once per year. This strategy will have to increase balances without feeling a significant pain from the reduction in your paycheck.
- Account Options for the Self Employed. Employers offer 401(k)s, 403Bs, or 457’s, which use pretax dollars and offer tax-deferred growth. Taxes will be incurred when withdrawals are made. Roth IRAs are available to both individuals and employees using after tax dollars. Small business owners, both full-time and part-time, qualify for additional retirement accounts such as a solo 401(k)s, SEP IRAs, Simple IRAs, or defined benefit plans. These accounts offer higher contribution limits of up to 20% of net earnings with a maximum contribution of $53,000 a year.
The responsibility for meeting retirement needs currently falls on the individual. Social Security will barely keep you above poverty level and pensions are disappearing. These factors make it essential for individuals to start early and pay closer attention to retirement needs throughout your career. Failure to do so can result in you working well beyond traditional retirement years and short of funds needed for a comfortable retirement. For a FREE debt analysis, contact Strategic Consulting today and speak with one of their specialists to learn what you can to prepare for a sound financial future.