Everything You Need to Know About 401(k) Plans, IRAs and Other Retirement Savings Accounts
Individual retirement accounts (IRAs)
How much should I save for retirement?
How should I invest my retirement money?
A critical component to building lasting wealth is paying yourself first — that is, consistently setting aside a portion of your income (ideally, 10-15%) for your future self. It’s important that this money goes into a pre-tax retirement account, which is a type of account that allows you to deposit a portion of your earnings before the government takes its usual cut out of them.
Taxes typically take at least 28 cents out of every dollar you earn. If you live in a state that has its own income tax, you’ll keep even less of your hard-earned dollars. But funneling your money into a pre-tax retirement account spares your money from this kind of shrinkage. When you put your earnings into one of these accounts, all 100 cents of your dollar go to work for you, and as long as the money stays in the account, it can continue to work for you without any interference from the tax man.
There are two main types of pre-tax retirement accounts: the kind your company provides for you (known as employer-sponsored retirement accounts) and the kind you provide for yourself (known as individual plans).
Below, I’m going to describe how these accounts work and how you go about setting them up and contributing to them.
Employer-sponsored retirement plans
If you’re an employee, chances are your company offers what are called self-directed retirement accounts. These plans allow you to contribute your own money to your own personal retirement account without paying taxes on it.
Let’s go over the different types of employer-sponsored plans.
The most popular retirement program that employers offer their employees is a 401(k) plan. It’s considered to be the mother of all retirement accounts and there are major benefits if you contribute to one:
- You’ll get big tax breaks. You contribute pre-tax money to a 401(k), so the more you add to your account, the more you reduce your taxable income and, therefore, your tax bill. You also don’t pay taxes on any of the returns you earn over the years (unlike regular investment accounts, which are taxable). You only pay taxes when you withdraw your earnings and contributions, but you’ll likely get taxed at a lower rate since, as a retiree, your income tends to drop, which puts you in a lower tax bracket than when you were fully employed.
- In 2020, you can put in as much as $19,500 a year. (If you’re 50 or older, you can contribute $6,500 more in “catch-up contributions,” for a total of $26,000.)
- Your contributions are automatically deducted from your paycheck. That means, once you sign up, that’s it! You don’t have to do anything. The percentage of your income that you elect to contribute will be automatically taken out of your paycheck and put into your 401(k).
- Your company may match a percentage of your contributions. Many employers offer a “401(k) match” and will match your contributions up to a certain amount. That’s essentially free money!
- By consistently contributing to your plan every time your paycheck lands, you’ll enjoy the miraculous benefits of compound interest. The money in your 401(k) plan is invested — when you open your plan, you need to select an investment (the account itself is just a holding tank), but more on that later. The important thing to note here is that over a lot of time, money compounds dramatically, so the sooner you start contributing to your retirement plan, the better.
A few notes on 401(k) plans: You can’t withdraw your money before age 59 ½ without paying a 10% penalty. Also, you can’t keep your money here forever — IRS regulations require you to make what’s called a required minimum distribution generally starting the year that you reach age 70 ½. If you don’t take the minimum distribution, you’ll owe a penalty. (Though, Congress suspended required minimum distributions for 2020 in response to the Covid-19 pandemic — meaning, instead of having to take money out this year, retirees can keep their investments growing.)
Many people mistakenly assume that if their company offers employees a 401(k) plan, they’re automatically included in it. This is almost never the case! At most companies, if you don’t sign up for the plan, you’re not in it. You should be able to join at no cost. Check with HR to make sure you’re properly signed up. If you’re not, enroll ASAP. (Some companies won’t let you join their 401(k) plan until you’ve worked there for some minimum amount of time. If this is the case for you, find out when you will be eligible and mark the date on your calendar.)
While you’re enrolling, check to see if you have the option of setting up “auto-increase,” which allows you to increase your contributions by a certain percentage every year (or however frequently you want). This is a great feature, especially if you’re starting off with a smaller contribution and want to eventually work your way up to saving more.
Roth 401(k) plans
In 2006, the Roth 401(k) plan option was introduced. It allows you to invest after-tax dollars (that means no tax deduction up front) into the plan — then, your money will grow tax-free until you take it out at age 59 ½ or later, just like a regular 401(k) plan. When you take your money out, however, the distributions are tax free.
If you’re young and your taxes are low, this account can make sense for you, since you’re paying taxes on this money now and not later, when you might be in a higher tax bracket. If you’re in a high tax bracket right now, I would pass on this new account and continue with the regular version.
If you can’t decide which way to go, you can always choose to use both options if your plan allows you to and put some money into a tax deductible 401(k) plan and some into a Roth 401(k) plan. Then you’ve covered both tax bases. Typically, people who do this split their contributions 50/50.
A Roth 401(k) plan does not have any income limits (unlike a Roth IRA, which I’ll explain later on), so high income earners can use this type of plan.
Other employer-sponsored retirement plans
If you work for a nonprofit organization such as a school or hospital, you will likely be offered a 403(b) plan, which works very similarly to a 401(k). (The numbers and letters refer to the parts of the tax code that established these various retirement plans.)
Some smaller companies may offer what is called a SIMPLE plan, a SEP-IRA or a defined-contribution plan. Whichever type your employer offers, you should be able to join it at no cost. Understand the contribution limits for the plan your employer offers. For a SIMPLE plan, for example, the amount an employee contributes from their salary cannot exceed $13,500 in 2020.
Individual retirement accounts (IRAs)
If your company doesn’t offer a retirement plan or if you’re self-employed, don’t panic! You can still pay yourself first and enjoy tax breaks if you open an IRA, which is a personal retirement plan that most anyone who earns an income can set up at a bank, brokerage firm or even online.
Like a 401(k), an IRA is not an investment itself. Rather, it’s a financial holding tank into which you can make tax-deferred contributions. When you open an IRA, you first decide how much to put in, then how to invest it.
There are a few different types of IRAs we’re going to go over:
With a traditional IRA, you contribute pre-tax dollars and let your money grow tax-deferred over time. While you don’t pay any income tax on the money you put into the account, you’ll pay taxes on your contributions and investment gains when you withdraw the money, which you can do starting at age 59 ½. (If you withdraw before, you’ll owe a penalty.) Like with a 401(k), there’s a required minimum distribution once you hit a certain age.
In 2020, you can invest up to $6,000 a year in a traditional IRA (up to $7,000 if you’re age 50 or older).
The biggest difference between funding a traditional IRA and a Roth IRA is when you pay taxes on the money.
With a traditional IRA, you’re contributing pre-tax money, but with a Roth IRA, you pay income tax on the money you put in. The good news about a Roth is that as long as your money has been in the account for at least five years and you are older than 59 ½ there’s no tax to pay when you take the money out. And unlike the traditional IRA, you can leave your money in a Roth account as long as you like. You don’t have to start making minimum withdrawals when you turn 70 ½.
With a Roth IRA, though, there’s an income cap, which the IRS sets each year based on modified adjusted gross income (MAGI). In other words, if you earn too much money, you aren’t eligible to contribute to a Roth. In 2020, you have to earn less than $196,000 as a married couple or less than $124,000 as a single person in order to contribute the full amount to a Roth IRA.
Traditional vs. Roth IRA. Which is right for me?
The choice of whether to go with an IRA or a Roth IRA really boils down to the question of whether you want your tax breaks up front or later on.
Which is better for you depends on what tax bracket you’ll be in when you retire, and that’s something you really can’t know for sure. But you can speculate: Common sense would tell you that you’ll probably be in a lower tax bracket, since you won’t be working anymore. But who knows what the tax laws will be by then.
According to most computer projections, if you are at least 15 years away from when you plan to begin withdrawing money from your retirement account, you’d probably do better with a Roth IRA.
When you’re ready to start funding an IRA, there are hundreds of banks, brokerage firms and mutual fund companies that you can choose from to open an account, including TD Ameritrade, Charles Schwab, Fidelity and Vanguard. You can also open IRAs with robo advisors like Betterment and Wealthfront.
If you’re self-employed or are a small business owner, you have an excellent retirement savings option called a SEP IRA, or a Simplified Employee Pension IRA. They’re easy to set up and don’t require much paperwork.
These plans are truly amazing. You can contribute as much as 25% of your gross income, up to a maximum of $57,000 for 2020. If you are self-employed and don’t have any employees, run to the nearest bank or brokerage firm and open a SEP IRA today. (Note that if you have employees, certain obligations go along with establishing a SEP IRA.)
You have other options as a business owner, including funding a self-employed 401(k) plan. Also referred to as solo or individual 401(k)s and intended for sole proprietors (business owners who don’t have any non-spouse employees on their payroll), these plans allow for greater savings: They let you contribute the regular maximum contribution you would be able to for an employer-sponsored 401(k) plan — that’s $19,500 in 2020 for workers under 50 — plus, a share designated as the employer’s share, which is equivalent to 25% of W-2 income or 20% of Schedule C or K-1 income.
It might sound a little complicated, since sole proprietors, like independent contractors and freelancers, technically wear both “employer” and “employee” hats, but the upshot is that it lets you sock away a lot more money than other retirement plans.
How much should I save for retirement?
As for how much to contribute to your retirement plan, I want you to aim to save 10% of your gross income. Of course, more is always better. And, in a perfect world, you’re maxing out your plan — that’s ultimately how you’re going to retire rich.
If you can’t afford to save 10% right now, contribute enough to get the full match if your company offers one. It’s OK to start off slowly, saving a smaller percentage of your income at first and gradually working your way up to where you need to be.
Even if you think the best you can do right now is to save just 1%, don’t let that stop you. Anything is better than nothing. At the same time, try to be ambitious. However much you think you can afford to save, do more. If you think you can save 4%, save 6%. If you think you can save 10%, save 12%. Most of us tend to underestimate how much we think we can manage. As a result, we wind up low-balling ourselves — and our futures.
How should I invest my retirement money?
Now that we’ve looked at the different types of retirement accounts that are available, let’s look at what to do with the money you put in your plan.
Whether you open a 401(k) plan at work or an IRA or a SEP IRA, once your money is deposited in the account, you need to select an investment. The account itself is just a holding tank. It’s the investment you select that determines how fast your money will grow. Whether it earns 1% or 10% depends on how you invest it. With a retirement account, it’s critical that you invest wisely, not gamble.
The best way to do this is to follow the old advice about not putting all your eggs in one basket. In other words, you need to diversify, which means that instead of investing all of your money in just one or two places, you spread it around. This doesn’t mean opening a bunch of different retirement accounts — this means building a diversified portfolio of stocks, bonds and cash investments in one retirement account.
Here are a few more good rules of thumb to follow when figuring out how to invest your retirement money:
- The younger you are, the more risk you can afford, since you have more time to ride out a bad stock market or other economic downturn. The opposite is true for someone who’s close to retirement or already retired.
- Rather than looking for individual stocks and bonds that match the particular risk profile that is right for your situation, I suggest you put your money in appropriate mutual funds or exchange-traded funds (ETFs). Mutual funds and ETFs not only offer professional money management, diversification and ease of use, but most now allow you to start investing with as little as $50.
- If you’re contributing to a 401(k) plan, many companies offer what are called target date mutual funds. These funds have a specific year in their name (for example, the 2030 fund or the 2040 fund), the idea being that you select the fund closest to your projected retirement date. They help you pick an investment fund of funds that will be professionally managed with a “target date of retirement.” Say you want to retire around 2035. You simply select the fund with “2035” in it. Then, the fund manager builds a diversified portfolio that will be automatically rebalanced over time, as you get closer to retirement.
The bottom line: Pre-tax retirement plans are where all wealth starts. I want you to think of contributing to one as a necessity. Please give yourself the opportunity to retire as early as you would like, with enough money to have all the fun you deserve.