When saving for retirement, one of the best things you can do is go at it from all angles. In other words, utilize all the available retirement accounts and take advantage of the tax breaks that come along with them. As you're planning your retirement, these three accounts can be your heroes.
1. A 401(k) plan
A 401(k) is the most popular type of retirement plan, mostly because it's offered through employers. With a 401(k), you make pre-tax contributions, lowering your taxable income for the year and putting the money aside for retirement before you can "see" it. When you set your 401(k) plan investments, you'll be given options to choose from, typically your company's stock (if it's a public company), index funds based on market capitalizations, and target-date funds that automatically rebalance as you near retirement.
As of 2022, the most you can contribute to your 401(k) annually is $20,500. You can make a catch-up contribution if you're 50 or older, allowing an extra $6,500. You must be 59 1/2 years old to take penalty-free withdrawals from your 401(k). If you withdraw money before then, you'll face income taxes and a 10% early withdrawal fee.
Even if you don't want or need to, you must take the required minimum distributions (RMDs) once you turn 72. If not, the IRS imposes harsh penalties.
If your employer offers a 401(k) plan, utilize it without thinking twice. It's a primary source of retirement income for many people.
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2. Roth IRA
Where a 401(k) plan may come up short, IRAs pick up much of the slack. Unlike a 401(k), IRAs aren't tied to an employer and must be opened on your own, similar to opening a bank or regular brokerage account. They also function much like brokerage accounts in that you can invest in any stock you want; you don't have to rely on the options provided to you.
What makes Roth IRAs so good is that your money essentially gets to grow and compound tax-free; you contribute after-tax money into a Roth IRA, and withdrawals are tax-free in retirement. Depending on how much you accumulate in a Roth IRA, having tax-free withdrawals in retirement can easily save you tens of thousands of dollars in taxes.
The maximum amount you can contribute to an IRA (both Roth and traditional combined) is $6,000. If you contributed $6,000 yearly to your Roth IRA and received an average of 10% annual returns over 25 years, you would have over $590,000. The difference between doing that in a Roth IRA and a brokerage company is that in a Roth IRA, all that money would be yours; in a brokerage account, the $440,000 in capital gains would be taxed.
If you're early in your career and this is likely the lowest tax bracket you'll be in, it makes sense to pay taxes on your contributions now instead of later when it could be more expensive. Roth IRAs also have income limits, so take advantage before you out-earn your eligibility.
3. Traditional IRA
Traditional IRAs operate like Roth IRAs, but the one thing that essentially sets them apart is when you get your tax break. With a traditional IRA, you get your tax benefits on the front end and a chance to deduct some or all your contributions. Your eligibility and the amount you can deduct depend on your income, filing status, and whether you have a retirement plan at work.
Like a 401(k), traditional IRAs also have RMDs -- and you can count Uncle Sam wants his cut. Since you got the tax break on the front end, the IRS forces you to take RMDs so that it doesn't become a situation where you get two tax breaks: one with the deduction and the other by not paying taxes on it in retirement.
If you're at the height of your career and this is likely to be the highest tax bracket you'll be in, it makes sense to take the tax break now when it's most valuable, instead of waiting until later when your tax bracket will likely be lower.
