When it comes to retirement planning, the sooner you get going the better. As Alan Kakein once said, failing to plan is planning to fail—particularly true in this case.
Sure, you might get Medicare, but it isn’t guaranteed, and living off the average social security payout alone would mean a very bare-bones lifestyle. The Social Security Administration estimated the average 2017 payout to be just $1,360 per month. Is that really how you want to spend your golden years?
Despite that, nearly half of Americans don’t have any retirement savings whatsoever, according to a 2016 report by the Economic Policy Institute.
Here are the most popular retirement account options. They fall into three categories: individual retirement plans, employer-sponsored retirement plans, and small business/self-employed retirement plans.
Individual Retirement Plans
The most popular type of retirement plan available outside of a place of employment is the individual retirement account (IRA). There are also solo 401(k)s and Health Savings Accounts (HSAs).
1. Traditional IRA. If you have taxable compensation and are under the age of 70½, you may contribute to a traditional IRA. There are no income limits. In 2017, individuals 49 and under may contribute up to $5,500 to a traditional IRA, while those between the ages of 50 and 70½ may contribute up to $6,500. You may claim a state and federal tax deduction for making contributions to a traditional IRA, but it will be limited if you or your spouse is covered by a retirement plan through work. Earnings in the account grow tax deferred (meaning more money to invest), but when you withdraw from a traditional IRA, you’ll owe full income taxes on contributions you got a tax deduction for and on any earnings. Unlike a Roth IRA, you must begin taking withdrawals, required minimum distributions (RMDs), by April 1st of the calendar year following the year you turn 70½.
2. Roth IRA. Roth IRAs have a special advantage over other retirement accounts, including traditional IRAs, because you can take out contribution at any time without penalty and often have a wider variety of investment options. Whereas one must be under the age of 70½ to contribute to a traditional IRA, you can contribute at any age so long as you have taxable compensation and meet income limits. In 2017, in order to contribute to a Roth IRA one’s modified adjusted gross income must be be under $133,000 for individuals or $196,000 for married couples filing jointly. Also in 2017, individuals 49 and under may contribute up to $5,500 to a Roth IRA, while those ages 50 and over may contribute up to $6,500. Unlike traditional IRAs, Roth IRA contributions are not tax deductible. Though contributions can be withdrawn from a Roth IRA at any time without incurring a penalty or tax (since taxes were paid on contributions before going into the account), it’s not so simple with earnings on contributions. In order to avoid a 10% penalty and having to pay the full income tax on earnings in a Roth IRA account, one must take a qualified distribution. A “qualified distribution” is any payment or distribution from your Roth IRA that is made following said five-year period and meets at least one additional requirement: being made by the date you reach the age of 59½, being used for a qualified first-time home purchase [it doesn’t take need to be your first], or [let’s hope this isn’t the case] either dead or disabled).
B. Individual Health Savings Account (HSA)
Individual HSAs are also a solid but relatively little-known retirement account option available to those with certain types of high-deductible health insurance plans (there is an employer-sponsored version as well). They allow for making post-tax, but tax-deductible, contributions to cover current and future healthcare expenses that aren’t covered by the plan. While funds withdrawn for eligible health-related expenses are not taxed, those for nonqualified expenses incur a 20% penalty on top of being taxed at the normal income tax rate if under age 65. But after 65, there is no penalty for nonqualified medical expenses, only taxation of account earnings (since contributions were already taxed). The 2017 contribution limits are $3,400 for an individual and $6,750 for a family. Accrued balances roll over at the end of the year.
C. Solo 401(k)
Self-employed individuals with no full-time employees and their spouses are eligible for the solo 401(k), also called the self-employed 401(k) or individual 401(k). It offers the same tax benefits, but is set apart from regular 401(k) plans, in part, because it is exempt from the complex regulations of the Employee Retirement Income Security Act of 1974 (ERISA).
Employer-Sponsored Retirement Plans
Employer-sponsored retirement plans, or qualified plans, are those established by an employer, who is incentivized by tax breaks. They are broken down into two categories: defined benefit and defined contribution plans.
A. Defined-Benefit Plans. In the case of defined-benefit plans, an employer promises to pay a certain amount to employees meeting certain eligibility criteria during their retiree years. These are commonly referred to as pensions, though technically pensions include defined-contribution plans such as 401(k)s. These are far less common than they once were and seem to be going extinct.
B. Defined-Contribution Plans. Defined-contribution plans, on the other hand, specify the contributions that an employer (including an individual who is self-employed) can make, not the benefit that will be received at retirement. The retiring employee receives the proceeds in a current or deferred lump sum or annuity. These include 401(k), 403(b), 457 plans, employee stock ownership plans, and profit-sharing plans.
These types of accounts come with special tax stipulations. First, participating employees defer a portion of their salary into the account, which reduces their taxable income and thus their present income-tax liability. Secondly, payment of taxes on growth in the account is deferred until withdrawal, allowing for greater growth since more money has more time to potentially grow in value and compound.
1. Early Withdrawal Penalty and Exceptions. If you withdraw money from a defined-contribution plan before turning 59½, the IRS takes 10% in addition to the standard income taxes. In the case of a Roth IRA, your initial contributions to the account must have made five years prior to withdrawal as an additional requirement to avoid the 10% penalty. There are some exceptions to the early withdrawal penalty, such as up to $10,000 for a first-time homebuyer.
a. 401(k), 403(b), and 457 Plans
401(k), 403(b), and most 457 plans are subject to annual contribution limits. In 2017 they are $18,000 for people ages 49 and under, and $24,000 for those ages 50 and over.
Note that distributions (such as dividends) from these accounts are taxed at the ordinary income tax rate instead of lower long-term cap gains tax rate.
i. Traditional 401(k) Plan. Employers sometimes offer matching their employees’ 401(k) contributions. Per a 2010 study by the Bureau of Labor Statistics, the average 401(k) match nets out to 3.5%, and their 2015 National Compensation Survey concluded that of the 56% of employers who offer a 401(k), 51% offer some form of a match. There is a 10% penalty for early distributions taken before reaching the age of 59½ for those who left their employer before age 55. If an individual left their employer at or after age 55 (50 for qualified public safety employees), any withdrawals will be treated as taxable income as is usual, but there won’t be a penalty on top of it.
ii. Roth 401(k) Plan. Roth 401(k)s are a type of defined-contribution plan that combines the features of a traditional 401(k) and a Roth IRA. Whereas traditional 401(k)s are funded with pretax money, Roth 401(k) contributions are made using after-tax dollars and thus are a better option for someone who expects to have lower income in retirement. Unlike Roth IRAs, there aren’t income limits, though contribution limits are in place and are the same as those for traditional 401(k)s. Like a Roth IRA, your account must been opened for at least five years and you must have reached the age of 59½ to avoid paying taxes on withdrawals of earnings in the account.
iii. 403(b) Plan. Also called tax-sheltered annuity (TSA) plans, 403(b) plans are available to employees of public schools, specific tax-exempt organizations, and certain types of ministers. There is a 10% penalty for early distributions taken before reaching the age of 59½ for those who left their employer before age 55. If an individual left their employer during or after age 55, any withdrawals will be treated as taxable income, but there won’t be a penalty on top of it.
iv. 457 Plan. Sometimes referred to as 457(b) plans, 457 plans are available to employees of governmental and specified nongovernmental organizations. Unlike the case with 401(k) and 403(b) plans, there is no 10% penalty for withdrawal before age 55, though withdrawals are subject to normal income tax.
b. Thrift Savings Plan (TSP). Thrift savings plans (TSPs) are exclusively available to current or former U.S. civil service employees and members of the uniformed services. They work similarly to 401(k)s; plan participants opt to divert a portion of their salary into it, which grows tax-deferred, taxed upon withdrawal. The 2017 contribution limit is $18,000 for those under age 50, and individuals age 50 or over may make catch-up contributions up to $6,000 per year. There is a deadline to begin taking withdrawals for those separated from federal service or the uniformed services: by April 1st of the year following the year you turn age 70½. There are additionally rules for required minimum distributions (a mandatory set annual amount) based on life expectancy.
c. Profit-Sharing Plan. A profit-sharing, or stock bonus, plan is a defined-contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise) based on a company’s quarterly or annual earnings.
d. Health Savings Account (HSA). Employer-sponsored HSAs are also a solid but relatively little-known retirement account option available to those with certain types of high-deductible health insurance plans (there is another version available outside of the workplace as well). Like a traditional 401(k), they allow for making pre-tax contributions directly from one’s paycheck to cover current and future healthcare expenses that aren’t covered by the plan. Employers may contribute to an employee’s HSA as well. While funds withdrawn for eligible health-related expenses are not taxed, those for nonqualified expenses incur a 20% penalty on top of being taxed at the normal income tax rate if under age 65. But after 65, there is no penalty, but only taxation of nonqualified medical expenses. The 2017 contribution limits (for employer and employee) are $3,400 for an individual and $6,750 for a family. Accrued balances roll over at the end of the year.
Small Business/Self-Employed Retirement Plans
A. Simplified Employee Pension Plan (SEP) IRA. A SEP is a retirement vehicle that allows employees to make tax-advantaged contributions to their own and their employees’ SEP-IRAs. SEPs are a good option for small businesses, in part due to their minimal reporting and disclosure requirements and therefore low administrative costs. Self-employed individuals can contribute to a SEP-IRA of their own. Unlike a traditional IRA, contributions may be made over the age of 70½.
B. Savings Incentive Match Plan for Employees (SIMPLE) IRA. SIMPLE IRAs are available to small businesses (100 or fewer employees) that do not have another qualified plan, and whose employees received at least $5,000 during the preceding year. Like SEPs, they are easy and cost-efficient to administer. Employees have the option of contributing on their own, on top of employer contributions.
C. Solo 401(k). Self-employed individuals with no full-time employees and their spouses are eligible for the solo 401(k), also called the self-employed 401(k) or individual 401(k). It offers the same tax benefits, but is set apart from regular 401(k) plans, in part, because it is exempt from the complex regulations of the Employee Retirement Income Security Act of 1974 (ERISA).