When it comes to saving for retirement, the sooner you get started, the better. But knowing which type of account to open can help you make the most of your contributions. Here, we'll discuss a few different retirement accounts and their associated benefits so you can make the best decision for your future.
Identifying the right account
Before we explore the various retirement accounts out there, let's talk about what you might be looking to get out of your plan. Whether you open a 401(k), traditional IRA, Roth IRA, or a different type of IRA, all of these accounts have one thing in common: They allow your money to grow on a tax-deferred basis so you don't have to worry about paying taxes on investment gains along the way. This allows you to reinvest your earnings to generate even more wealth over time.
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Depending on the type of plan you choose, you might also get the benefit of tax-free contributions. All of the aforementioned accounts aside from the Roth are funded with pre-tax dollars, though once retirement rolls around, your withdrawals are subject to ordinary income taxes. Roth accounts are funded with after-tax dollars, but withdrawals in retirement are taken tax-free, which essentially means you don't ever pay taxes on whatever growth your money achieves. Another key difference between Roth accounts and all others is that Roth accounts don't impose required minimum distributions, which means you can let your money sit and grow indefinitely.
Now that we've covered some of the basics, let's dig a little deeper into the various account types that may be available to you.
401(k) plans
Employer-sponsored 401(k) plans offer some of the highest annual contribution limits as far as retirement accounts go. Currently, workers under 50 can contribute up to $18,000 a year, while those 50 and older can contribute up to $24,000. These generous annual limits make 401(k) plans a valuable tool for strong savers in particular, as traditional and Roth IRAs have a much lower yearly contribution cap.
The downside of 401(k)s is that not everyone has access to one. A good 41% of workers don't have the option to participate in an employer-sponsored 401(k) plan. Another drawback of 401(k)s is that they typically offer fewer investment choices than IRAs. On the flip side, though, more than 90% of employers offer some type of 401(k) match, so if you enroll in your company's plan, you could get some free money out of the deal.
Traditional and Roth IRAs
IRAs are known to offer a wide range of investment options, which not only give you more choices for growing your money, but can also help keep your investment fees to a minimum. But there's a downside to opening an IRA, be it a traditional account or the Roth variety, and it's that your annual contributions are capped at $5,500 if you're under 50, or $6,500 if you're 50 or older.
Now if you're not planning to save much for retirement in the coming years, these limits may not seem so restrictive. But if you have considerably more money to contribute, and you don't have access to a 401(k), you may need to look at other income-generating options in addition to an IRA, whether it's an annuity or a traditional, non-tax-advantaged brokerage account.
Furthermore, you should know that not everyone is eligible to contribute to a Roth IRA. If you earn more than $133,000 as a single tax filer, or more than $196,000 as a couple filing jointly, you can't capitalize on the Roth option directly -- though you can look into a backdoor Roth IRA, which allows you to convert a traditional account into a Roth.
IRAs for the self-employed
If you work for yourself or run your own small business, you have two additional IRA types to choose from. First, there's the SEP IRA, which works just like a traditional IRA only with a higher annual contribution limit. This year, you can contribute up to 25% of your income for a maximum of $54,000. However, you should be aware that this option could get expensive if you have employees, as you must contribute the same amount percentage-wise to their accounts as you do for your own.
Then there's the SIMPLE IRA, which also offers higher annual contribution limits than the traditional or Roth. Currently, you can put in up to $12,500 per year if you're under 50, or $15,500 if you're 50 or older. If you're an employer, you're also required to match employee contributions by either kicking in a fixed rate of 2% of every employee's compensation (regardless of participation in the plan), or by matching employee contributions up to a maximum of 3% of salary. If you're self-employed and don't have employees, you can contribute to a SIMPLE IRA as both employer and employee.
You might consider a SEP or SIMPLE IRA if you wish to contribute more than $5,500 a year toward retirement ($6,500 if you're 50 or older), or if you're looking to capitalize on a year of strong earnings. Many self-employed workers have variable income, but if you have a year where you make more money than expected, a SEP or SIMPLE IRA is a good place to stick that excess cash.
Some final notes
No matter which type of plan you choose to open, once you fund your account, you should be prepared to leave that money where it is until you're ready to retire. Withdrawing funds prior to age 59 and a half could result in a 10% penalty unless you have a Roth account, which is the only option that allows you to withdraw your principal contributions penalty-free at any time. Also, keep in mind that unless you have a Roth, you'll be required to start taking distributions once you reach age 70 and a half -- and that comes with some tax implications as well.
Ultimately, the type of retirement account you open will probably boil down to which options you're eligible for in the first place, how much you're looking to contribute each year, and when you want to reap the tax benefits involved. Regardless of the plan you select, do yourself a favor and start contributing to it regularly as early as possible. The sooner you get started, the better that account will serve you in the long run.
