29 Dec How Do You Choose the Right Accounts for Retirement?
How Do You Choose the Right Accounts for Retirement?
If you’ve looked into choosing retirement accounts and felt like it’s a big bowl of alphabet soup with all the IRAs and 401(k)s and Roth and SEP, then you’re not alone. There are many different types of retirement accounts out there, but which ones are best for your situation?
Regardless, the more you understand about retirement accounts, the better the chances of you setting attainable investment goals and achieving them. Before discussing the type of accounts you need, let’s talk about the different types of accounts out there.
Qualified and Nonqualified Accounts
There are two types of accounts: nonqualified and qualified. The difference between these accounts is in four main areas: growth, access, taxes, and contributions. Some plans are taxed up-front while others are taxed when you withdraw funds. Some plans allow funds to be accessible at any time (with a fee) while others are basically untouchable. Some require minimum contributions and distributions whereas others offer more flexibility. Growth also varies depending on the type of account. Here are some basics on the differences between qualified retirement accounts and nonqualified retirement accounts.
Nonqualified accounts are taxed at the end of each year. You pay taxes on interest, dividends, or capital gains. Examples of nonqualified accounts include checking, savings, and investment accounts. The great thing about these accounts is that you can access your funds at any time without restrictions. Plus, you can make unlimited contributions and save as much as you want.
Qualified accounts, on the other hand, are accounts where you defer your taxes, so the funds grow tax-free until you withdraw. These are usually actual “retirement accounts” such as IRAs, 401(k)s, Roth IRAs, and Simple and SEP retirement plans. There are limits on how much you can contribute to these accounts, and your funds are not as easily accessible (unless you want to pay a penalty). Let’s take a closer look at these plans.
Traditional IRA
Anyone can utilize a traditional IRA. With this plan, you are allowed to make yearly contributions up to $5,500. If you are over age 55, you can make a catch-up contribution. If you withdraw money prior to age 59.5, you will pay a 10% early withdrawal fee plus pay income taxes. At 70.5 years of age, you are required to take a mandatory distribution. The funds in this account grow tax-deferred.
Additionally, if your IRA is not sponsored by your employer, you are eligible for a full tax deduction on your contribution to your IRA, even if you’re a high earner.
Roth IRA
The funds in this account grow tax-free as long as they have been in the account for at least 5 years and you don’t withdraw them prior to 59.5 years of age. You won’t get a tax deduction each year for your contributions to your Roth IRA, but the benefit is that you can withdraw the funds tax-free after age 59.5.
Unlike other retirement plans, with a Roth IRA, you are not required to take minimum distributions once you reach a certain age. However, there are contribution limits you must consider.
401(k) Plan
These retirement plans are probably the most common and convenient since you can arrange through your employer for your contributions to be taken directly out of your paychecks. You are allowed to contribute $18,500/year which grows tax-deferred. Generally, the same rules apply like a traditional IRA. Many employers choose to match their employees’ funds, and after age 50, you can make yearly catch-up contributions too.
Simple IRA
This is a retirement plan in which you are allowed to contribute up to $12,500 yearly. This account grows tax-deferred and follows the same rules as a traditional IRA. You’ll generally find this type of IRA offered through smaller businesses since paperwork and managing Simple IRAs is much, well, simpler! (Hence, the name.) Employers usually contribute or match employees’ funds, but it depends on exactly how it’s set up. Another bonus: there’s a $3000/year catch-up contribution option if you’re age 55 or older.
Simplified Employees Pension Plan IRA
This account (also known as SEP IRA) is great for people with self-employment income or for small business owners. It allows the business owner to contribute up to 25% of an employee’s income up to $53,000. Unlike the Simple IRA and 401(k) plan, there’s no catch-up contribution option.
Health Savings Account
Health savings accounts (also known as HSA), are typically used to save for medical expenses, but some people are getting creative and using them as a sort of retirement account. This money is tax-free, and although there are contribution limits, once you reach age 55, you can contribute $1000 more per year to your HSA. Not only is your HSA tax-free, but also you get a tax deduction for it! Your HSA funds roll over to the next year if you don’t use them; this is helpful if you end up having health issues later in life and need to pay for allowable medical procedures, medications, and treatments.
Please note: you will have to pay taxes and a 20% withdrawal fee if you use the money before age 65 for anything other than medical needs. After age 65, you can use your HSA funds for any reason, but you’ll still have to pay taxes on the amount you withdraw. But if you carefully save your medical receipts, you can actually pay yourself (tax-free!) for past medical expenses—even from years ago! If you’re 65 or older, healthy, and don’t need to use your HSA for medical needs, you can withdraw the funds, pay taxes, and invest the money elsewhere. This is how some people are creatively using their HSA as another “retirement account.”
If you still feel like you’re swimming in alphabet soup after this explanation, it may be time to call upon a qualified financial planner to help you sort through it all. There are few things as important as making sure your retirement plan is sufficient for your long-term goals, so don’t put your head in the sand. Reach out to a knowledgeable adviser today!
