With mounting concerns over Social Security, and a languishing number pensions, it’s more important than ever to start investing for retirement. Tax advantaged retirement accounts offer investors the best opportunities to see their investments grow, but the accounts come with fine print. These are the things you need to know before you start investing.
What are employer sponsored retirement accounts?
Employee sponsored retirement accounts often allows you to invest pre-tax dollars in an account that grows tax-free until a person takes a distribution. In some cases, you may have access to a Roth retirement account which allows you to contribute post-tax dollars. Contributions to employer sponsored retirement accounts come directly from your paycheck.
The most common employee sponsored retirement accounts are defined contribution plans including a 401(k), 403(b), 457, and Government Thrift Savings Plan (TSP). Private sector companies operate 401(k)s, public schools and certain non-profit organizations offer 403(b)s, state and local governments offer 457 plans, and the Federal government offers a TSP. Despite the variety of names, these plans operate the same way.
According to the Bureau of Labor Statistics, 61% of people employed in the private sector had access to a retirement plan, but just 71% of eligible employees participated.
How much can I contribute?
If you’re enrolled in a 401(k), 403(b), 457, or TSP, then you can invest up to $18,000 dollars to your employer sponsored retirement accounts per year in 2016. If you qualify for multiple employer sponsored plans, then you may invest a maximum of $18,000 across all your defined contribution plans. People over age 50 may contribute an additional $6,000 in “catch-up” contributions or $3,000 to a SIMPLE 401(k).
In addition to your contributions, some employers match contributions up to a certain percentage of an employee’s salary. Visit your human resources department to learn about your company’s plan details including whether or not they offer a match.
What are the benefits of investing in an employer sponsored retirement plan?
For employees that receive a matching contribution, investing enough to receive the full match offers unparalleled wealth building power, but even without a match, employer sponsored plans make it easy to build wealth through investing. The funds to invest come directly out of your paycheck, and the plan invests them right away.
However, there are fees associated with these accounts. Specific fees vary from plan to plan, so check your company’s fee structure to understand the details, especially if you aren’t receiving a match. If you don’t have an employer match, then it may make more sense to contribute to your own IRA in lieu of the employer-sponsored plan.
Investing in an employer sponsored means getting to defer taxes until you withdraw your investment. Selling investments in a retirement plan does not trigger a taxable event, nor does receiving dividends. These tax benefits provide an important boost for you to maximize your net worth.
In addition to tax deferred growth, low income investors qualify for a tax credit when they contribute to a retirement plan. Single filers who earn less than $41,625 or married couples who earn less than $61,500 qualify for a Saver’s Tax Credit worth 10-50% of elective contributions up to $2000 ($4000 for married filers).
What are the drawbacks to investing in an employer sponsored retirement plan?
Investing in an employer sponsored retirement plan reduces the accessibility of the invested money. The IRS punishes distributions before the age of 59 ½ with a 10% early withdrawal penalty. These penalties come on top of the income taxes that you must pay the year you take a distribution. In most cases, if you withdraw money early pay so much in penalties and increased income tax rates (during the year you take the distribution) that you would have been better off not investing in the first place.
Additionally, investing in an employee sponsored retirement plan reduces investment choices. You may not be able to find investment options that fit your investing style through their company’s plan.
Should I take a loan against my 401(k) balance?
Since money in 401(k) plans isn’t liquid, some companies allow you to take a loan against your 401(k). These loans tend to be low interest and convenient to obtain, but the loans come with risks that traditional loans do not have. If your job is terminated, most plans offer just 60-90 days to pay off the loan balance, or the loan becomes a taxable distribution that is subject to the 10% early withdrawal penalty and income tax.
It is best to only consider a 401(k) loan for a short term liquidity need or to avoid them altogether.
What if I don’t qualify for an employer sponsored retirement plan?
If you’re an employee, and you don’t have access to an employer sponsored retirement plan you have to forgo the tax savings and other benefits associated with the accounts, but you may still qualify for an Individual Retirement Account (IRA).
However, if you pay self-employment taxes then you can create your own retirement plan. Self-employed people (including people who are both self-employed and traditionally employed) can start either a Solo 401(k) or a SEP-IRA.
A Solo 401(k) allows an elective contribution limit of 100% of self-employment income up to $18,000 (plus an additional $6000 in catch up contributions for people over age 50) plus if your self-employed, then you can contribute 20% of your operating income after deducting your elective contributions and half of your self-employment tax deductions (up to an additional $35,000).
If you qualify for both a Solo 401(k) and other employer sponsored retirement plan, then you cannot contribute more than $18,000 in elective contributions among your various plans.
A SEP-IRA allows you to contribute 25% of your self-employed operating income into a pre-tax account up to $53,000.
What are Individual Retirement Accounts?
Individual Retirement Accounts (IRAs) allow you to invest in tax advantaged accounts. Traditional IRAs allows you to deduct your investments from your income, and your investments grow tax free until they are withdrawn (at which point they are subject to income tax). You can contribute after-tax money to Roth IRAs, but investments grow tax free, and the investments are not subject to income tax when they are withdrawn in retirement. There are income restrictions on being eligible for deductions and these vary based on household income and if an employer-sponsored retirement plan is available to you (and/or your spouse).
What are the rules for contributing to an IRA?
In order to contribute to an individual retirement account, you must meet income thresholds in a given year, and you may not contribute more than you earn in a given year. The maximum contribution to an IRA is $5500 ($6500 for people over age 50).
A traditional IRA allows you to defer income taxes until you take a distribution. Single filers who earn less than $61,000 are eligible deduct one hundred percent of deductions, and single filers who earn between $61,000 and $71,00 may partially deduct the contributions. Couples who are married filing jointly may make contribute the maximum if they earn less than $98,000, and they may make partial contributions if they earn between $98,000 and $118,000.
Roth IRAs allow participants to invest after tax dollars that are not subject to taxes again. The tax free growth and distributions can be especially beneficial for those who expect to earn a high income (from investments, pensions or work) during retirement. Single filers who earn less than $117,000 can contribute the full $5,500, and those who earn between $117,000 and $132,000 can make partial contributions. Couples who are married filing jointly who earn less than $184,000 may contribute up to $5500 each to Roth IRAs, and couples who earn between $184,000 and $194,000 are eligible for partial contributions.
What are the benefits to investing in an IRA?
The primary benefits to investing in an IRA are tax related. Traditional IRAs allow you to avoid paying income taxes on your investments until you are retired. Most people fall into a lower income tax bracket in retirement than during their working years, so the tax savings can be significant. Roth IRA contributions are subject to taxes the year they are contributed, but the IRS never taxes them again. Investments within an IRA grow tax free, and buying and selling investments within an IRA does not trigger a taxable event.
Additionally, low income investors also qualify for a tax credit when they contribute to a retirement plan. Single filers who earn less than $41,625 or married couples who earn less than $61,500 qualify for a Saver’s Tax Credit worth 10-50% of elective contributions up to $2000 ($4000 for married filers).
IRAs also allow individuals to choose any investments that fit their strategy.
What are the drawbacks to investing in an IRA?
Investing in an IRA reduces the accessibility of money. Though it is possible to withdraw contribution money for some qualified expenses, many distributions are to be subject to a 10% early withdrawal tax penalty when a person takes a distribution before the age of 59 ½. In addition to the penalty, the IRS levies income tax on distributions the year that you take a distribution from a Traditional IRA.
Should I withdraw money from my IRA?
Taking a distribution from an IRA means less money growing for retirement, but many people use distributions from IRAs to meet medium term goals or to resolve short term financial crises. The IRS publishes a complete list of qualified exceptions to the early withdrawal penalty.
If you have to pay the penalty, withdrawing from an IRA is not likely to be the right choice. Once the money is withdrawn from an IRA it can’t be contributed again. For short term needs, taking out a loan usually comes out ahead.
What’s the smartest way to invest?
Investing between 15-20% of your gross income for 30 years often yields a reasonable retirement nest egg, but even if you can’t invest that much right now, it’s important to get started. The smartest place to invest for retirement is within a tax advantaged retirement account.
If you don’t have access to an employer sponsored plan the best place to start is by investing in an IRA. On the other hand, if you have access to both an employer sponsored plan and an IRA, the answer is not as clear. Anyone who has an employer with a matching policy should aim to invest enough to take full advantage of any matching plan that your company has in place.
After taking advantage of a match, the next best option depends on your personal situation.
Employer sponsored plans and Traditional IRAs offer immediate tax benefits that can be advantageous for high income earners. However, investing in a Roth IRA keeps money more liquid than either an employer sponsored plan or a traditional IRA.
Of course, the best possible scenario for your retirement is to maximize contributions to both an employer sponsored account and an individual retirement account, but you should carefully weigh how investing in these accounts affects your whole financial picture and not just your retirement goals.