Understanding Retirement Savings Accounts
7 min read •
30 sec brief
There are several different retirement accounts you can choose from - but what are the intricacies of each and how do you know if they'll work for you? This article gives you a high level overview of different retirement accounts.
No matter where you go, you’ll hear about retirement savings. Depending on where you are on the path, retirement may seem like far away. It’s important to pre-plan to make your golden years the best they can be!
There are several ways to save for retirement. Let’s explore four of the most common ways to build a nest egg.
A 401(k) is an employer-based retirement savings account, also known as a defined-contribution plan.
You make pre-tax contributions from your pay, lowering your annual taxable income. Say you make $4,000 a month and contribute $300 to your 401(k), only $3,700 of your monthly earnings will be subject to tax. The money in your 401(k) account grows tax-free.
In 2020, the 401(k) contribution limit is $19,500. Those over 50 can make an additional $6,500 catch-up contribution.
Some employers will help you build your 401(k) savings. Some companies offer an employer match, meaning they will match an employee’s contribution up to a certain percentage. For example, they may contribute 50 cents for every dollar you add, up to 6% of your pay. Be sure to ask for the specifics of your company's plan to maximize your retirement savings.
Some employers will contribute to employee 401(k)s even if you don’t add your own money, and some may provide a match in company stock.
Be sure to ask about a vesting schedule. You’ll likely have to work for that employer for a certain amount of time before the money is 100% yours.
Using Your 401(k)
There are a few ways to get money out of your 401(k). You can take a regular 401(k) withdrawal, an early 401(k) distribution, or rollover your 401(k) to an IRA. Each option has different tax rules.
If you still work for the employer, some plans offer 401(k) loans, hardship withdrawals or in-service distributions as ways to take money out of a 401 (k). Check with your plan administrator to find out if they allow these options.
If you’re no longer employed by the company, contact the 401(k) administrator to find out how to take money out of the account. You can’t take out a 401 (k) loan or hardship withdrawal, but you can take a distribution or rollover your 401(k) to an IRA.
Health Savings Account (HSA)
A Health Savings Account - or HSA - is a medical savings account that offers triple tax benefits to those enrolled in a qualified High Deductible Health Plan (HDHP).
The money you contribute to an HSA is not subject to federal income tax when you deposit it. In addition, any funds left in the account roll over year to year, allowing the balance to grow.
You can use the HSA funds to pay for qualified medical expenses any time without federal tax liability or penalty. Money used for non-medical expenses provide tax advantages if taken out after retirement age, but may incur penalties if taken earlier.
In 2020, the contribution limit for individual coverage is $3,550 and $7,100 for family coverage. For those 55 or over, you can contribute an extra $1,000.
Using Your HSA
There are a few ways to use the money in your HSA, including using the money for qualified medical expenses, taking a non-qualified withdrawal or using the funds for anything, once you’ve hit 65.
Using an HSA for qualified medical expenses is pretty straightforward. Many plans come with a debit card or have an easy reimbursement process. You can take a non-qualified withdrawal, but know that the money will be subject to income tax and an additional 20% tax.
Once you hit 65, you can spend your HSA funds on anything you want. The distributions will be taxed (like ordinary income), but you can then use the money for anything.
An Individual Retirement Account - or IRA - is an account that allows you to save for retirement with tax-free growth or on a tax-deferred basis.
You can contribute 100% of earned income up to a specific maximum dollar amount. The IRS does not assess any capital gains or dividend income taxes until you make a withdrawal.
In 2020, you can contribute up to $6,000 if you are under 50 and $7,000 if you are over 50.
You can only contribute earned income to an IRA. Earned income comes from working for someone who pays you or running your own business. This income includes money from wages, salaries, tips, bonuses, commissions, as well as self-employment income. Additionally, disability retirement benefits are considered earned income until you reach the age you would have received a pension or annuity.
Some types of income don’t count as earned income such as alimony, child support, rental property income, dividend interest, retirement income, and others.
Of note, if your earned income for the year is less than the contribution limit, you can only contribute up to what your earned income was. So, if you earned $3,000, you can only contribute $3,000, even though the limit is higher than that.
Using Your Traditional IRA
Technically, you can take money out of an IRA anytime. If you take money out before the age of 59 ½, you must meet certain IRS expectations, or you’ll have to pay a 10% penalty tax.
IRA distributions count as taxable income. It’s vital to claim any withdrawals as income on your annual tax return. The amount of tax you pay will depend on your marginal tax rate, which takes your other total income and deductions into account.
Traditional IRAs have what are called required minimum distributions you must take once you reach 70 ½. The withdrawal amount is determined based on a formula that is annually recalculated based on your age and prior year-end account balance.
Roth IRAs are tax-advantaged retirement saving accounts that let you withdraw your savings tax-free. You fund a Roth IRA with after-tax dollars. The contributions are not tax-deductible. Once you begin making withdrawals, the money is tax-free.
For 2020, you can contribute $6,000 if you are under 50 and $7,000 if you are over 50 to your Roth IRA.
Getting Money Out of Your Roth IRA
An interesting fact about Roth IRAs is that they have no required minimum distributions. In fact, you’re not required to withdraw any money at any age - you don’t have to withdraw in your lifetime at all - making them excellent wealth-transfer vehicles.
You can withdraw money - penalty and tax-free - equivalent to your Roth IRA contributions any time, for any reason even before you turn 59 ½.
If you want to withdraw earnings, different rules apply. Typically, you’ll face a 10% early withdrawal penalty when you withdraw the earnings. However, if you’ve had the Roth IRA for five years and one of the following apply to you, you can avoid this penalty:
- You’re 59 ½ or over
- You have a permanent disability
- You pass away and the money is withdrawn by your estate or beneficiary
- You use the money for a first-time home purchase (up to a $10,000 lifetime max)
Even if you’ve had the account for less than five years, you can avoid the penalty if:
- You’re 59 ½ or over
- The withdrawal is due to a disability
- The withdrawal is due to certain financial hardships.
- Your beneficiary or estate withdrew the money after you passed away
- You use the money (up to a $ 10,000-lifetime maximum) for a first-time home purchase, qualified education expenses, or certain medical costs.
This gives you an idea of what to expect with each of the four most common retirement plans. Keep in mind, each plan has its own rules. No matter what plan you have, get to know the in’s and out’s to maximize your retirement savings.
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