LAST REVIEWED Oct 29 2020 9 MIN READ
By The Human Interest Team
Unfortunately, most workers can’t count on a pension plan or Social Security to cover their costs during retirement. Pensions are rare, and Social Security may not protect future generations. You may want to invest in other types of retirement accounts such as Individual Retirement Accounts (IRAs) or 401(k)s. These retirement plans offer tax advantages to encourage employees to prepare for retirement. Here’s some more information about the types of retirement plans available.
A 401(k) plan is a benefit offered to employees through an employer. It lets you contribute part of your pre-tax paycheck. That way, you can lower your taxes and earn interest on money that would normally go to the IRS. Your investment will grow tax-free until you start making withdrawals. However, you could need to pay a 10% penalty if you start withdrawing funds before you turn 59 1/2.
Some employers will match a percentage of 401(k) contributions. However, many businesses require workers to be vested, meaning that only people who stay with the company for a certain period of time can take matching contributions with them when they leave. If you leave sooner, some employers will allow you to take a percentage of their contributions but not the whole match. Most companies let you invest in your 401(k) through automatic payroll detections, so you won’t need to remember to save for retirement every month.
As of 2020 (same holds for 2021), the IRS limits yearly 401(k) contributions to $19,500 for people under 50 and $26,000 if you’re 50 or over. The limit for combined employee and employer contributions is $57,000 or $63,500 with catch-up contributions. Similar accounts include 403(b)s for educators and nonprofit workers and 457(b)s for government employees.
Roth 401(k) plans
A Roth 401(k) has mostly the same rules as a traditional 401(k), but it uses post-tax dollars instead of pre-tax money. You won’t get a tax break for contributions, but you won’t need to pay taxes on your withdrawals. If you think your income and your tax bracket will increase, paying taxes now with a Roth 401(k) could be more economical than waiting to pay with a traditional 401(k).
Individual Retirement Accounts
If you’ve invested the maximum amount in your 401(k) or your employer doesn’t offer one, you may want to think about getting an Individual Retirement Account (IRA). You can open an IRA through a bank or brokerage firm and use it to purchase mutual funds, bonds, stocks, or other types of investments. Some people make these investment decisions themselves, and others hire a professional.
If you’re under age 50, you may contribute up to $6,000 annually. If you’re 50 or more, you can invest $7,000. Like a 401(k), your investments will grow tax-free and you’ll pay taxes when you make withdrawals. You can deduct the money you add to your IRA when you file your taxes, but there are some restrictions based on income. Similar to a 401(k), if you make a withdrawal before you reach age 59 1/2, you could have to pay a 10% fee.
With a traditional IRA, you must start taking RMDs when you turn 72. No matter how much you make every year, you can contribute the same amount to a traditional IRA, but your tax deductions could be limited if you or your spouse has another retirement plan through your employer. Your income and tax filing status can change the deductions you can take instead of your contribution limit.
If you and your spouse aren’t covered by employer-based plans and you’re a head of household, single, a qualified widow or widower, married filing jointly, or married filing separately, you can deduct the full amount of your contribution no matter how much you make.
People who have a retirement plan at work and are qualified widows or widowers or married filing jointly can take advantage of the full deduction as long as their Modified Adjusted Gross Income (MAGI) is $104,000 or less. If your MAGI is $104,000 to $124,000, you can take a partial deduction, and if your MAGI is over $124,000, you won’t be able to deduct payments to your traditional IRA.
If you have a plan at work, you’re single or a head of household, and your MAGI is $65,000 or less, you can deduct the full amount. You’ll get a partial deduction if you make between $65,000 and $75,000, and you won’t get a deduction if you make more. If your spouse has a plan at work, you’re married filing jointly, and your MAGI is $196,000 or less, you can deduct the full amount. People who earn $196,000 to $206,000 can get a partial deduction, and those who make more can’t take any deductions.
A Roth IRA has most of the same rules as a traditional IRA, but it uses post-tax funds. You can’t deduct the money you place in a Roth IRA when you file your taxes, but you won’t need to pay any taxes when you start making withdrawals.
Roth IRAs don’t have any Required Minimum Distributions (RMDs) during the owner’s lifetime, making them excellent vehicles for transferring wealth to heirs. There’s no penalty for withdrawals as long as it’s been five years since your first contribution and you’re older than 59 1/2. However, your income and tax filing status can impact your Roth IRA contribution limit. If your income is too high, you won’t be able to add funds to your account.
If you’re married filing jointly or a qualified widow or widower with a MAGI of less than $193,000, you can invest the full amount. If your MAFGI is between $196,000 and $206,000, your contribution limit will be reduced. People who make more than $206,000 can’t make contributions.
If you’re single, a head of household, or married filing separately and you didn’t spend any time living with your spouse during the year, you can invest the full amount as long as your MAGI is below $124,000. Your limit will be reduced if you make $124,000 to $139,000, and you won’t be able to place anything in your account if you make $139,000 or more.
You can put money in a traditional IRA along with a Roth IRA, but the total amount you add to both plans can’t exceed your yearly limit. A Roth IRA is an ideal place to save if you think your income will grow. However, it only provides tax savings if your tax rate rises after you retire.
Modern retirement account providers such as Human Interest provide more flexible plans with a wider variety of investment options. We can help small businesses attract and retain quality employees by offering 401(k)s and 403(b)s with full service and low fees. Contact us to learn more about your options.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.