Money Girl explains 3 different types of retirement accounts you can use to grow a healthy nest egg.
You know that you should be saving for retirement. But retirement accounts can be really difficult and time-consuming to figure out. Well, we’re going to cut the confusion.
This is the first episode in a 2-part series that will give you the basics of 6 different retirement plans created for individuals, employees, and businesses. It’s time to use them to turbo-charge your savings so you have a secure, happy financial future.
A retirement plan is a special account created by the IRS that allows you to save for the future and get money-saving tax breaks. Depending on your work and financial situation, you may qualify for several of them.
Here are 3 of the most common types of retirement plans:
Type #1: Traditional IRA
IRA is short for Individual Retirement Arrangement, which means it’s a plan for individuals only. You can’t own it with another person, not even a spouse. You manage every aspect of an IRA, such as opening the account, sending contributions, and deciding how to allocate your money.
An IRA itself is not an investment—it’s simply an account. Once you contribute money to it, you might choose to invest it in things like stocks, bonds, or mutual funds. Or you could keep some or all of your money in a savings account or CD.
You can move money and buy and sell investments within an IRA without paying a penalty. Your contributions, including all earnings and investment gains in the account, aren’t taxed until you make a distribution. However, if you take money out of the account before age 59½, you’re typically subject to income tax plus an additional 10% early withdrawal penalty.
Another rule is that if you (or a spouse) participate in a retirement plan at work, some or all of your contributions to a traditional IRA may not be tax deductible. For 2013, the most you can contribute to any type of IRA is $5,500 or $6,500 if you’re age 50 or older.
If you earn $45,000 and contribute $5,000 to a traditional IRA, you’re taxed on $40,000 only—not on $45,000. That’s why a traditional IRA is a great way to save for the future and cut your taxes in the current year.
Related Content: What Is the Difference Between a Traditional and Roth IRA?
Type #2: Roth IRA
A Roth IRA is subject to all of the major rules that apply to a traditional IRA—except when it comes to taxes. Your contributions to a Roth IRA are taxed up front, but all your withdrawals during retirement are completely tax free.
And speaking of withdrawals, you don’t have to take any money out of a Roth IRA as long as you live. With a traditional IRA, on the other hand, you’re required to start drawing down the account after you reach age 70½.
Additionally, you can withdraw contributions you’ve make to a Roth IRA before retirement without triggering tax or penalties. However, this doesn’t apply to growth in the account. Earnings withdrawn before the age of 59½ would be fully taxable and subject to the 10% early withdrawal penalty.
For 2013, the same combined contribution limit to all of your Roth or traditional IRAs is $5,500 or $6,500 if you’re age 50 or older. However, the Roth IRA has limits based on income and filing status. Therefore, if you make too much money, you might not qualify to make new Roth IRA contributions.
Read Your Guide to the Roth IRA, Part 1, to find out if you qualify for a Roth IRA. If you are eligible, making Roth contributions is a smart way to avoid paying tax on decades of earnings and growth on investments held in the account. Even if you make too much, you may still be able to convert money into a Roth IRA. Find out how in What Is a Backdoor Roth IRA?.
Related Content: How to Make Decisions About Personal Finances?
Type #3: 401(k) Plan
A 401(k) is a workplace retirement account. That means it can be offered by an employer as a benefit to employees. Eligible workers have the option to contribute a portion of their wages to an individual account. If you work for a school, church, or nonprofit organization, you may have a variation on this plan, which is called a 403(b).
Contributions, also known as elective salary deferrals, are taken directly out of your paycheck on a pre-tax basis. You choose how to allocate money in the account based on a menu of available investment and savings options.
Just like with a traditional IRA, your contributions and earnings in a 401(k) are never subject to tax until you take distributions during retirement. But if you take money from the plan before age 59½, you’re also subject to taxes plus a 10% early withdrawal penalty. However, some employers may offer 401(k) loans.
The best part about a 401(k) is that many employers make contributions on your behalf, match your contributions, or do both. For instance, they could match what you contribute each year up to 3% of your salary. That means if you’re not contributing enough to max out an employer’s match, you’re ignoring a really nice benefit and leaving money on the table.
Contributions that your employer makes can be subject to a vesting schedule, which means you have to remain employed for a certain period of time before you own them. However, you always own 100% of the money you contribute from your paycheck, in addition to the earnings on your contributions.
When you leave an employer, you can take your vested 401(k) money with you. You have the option to cash out the plan and pay income taxes on the full amount. However, a better option is to roll over your money into another retirement account, such as a traditional IRA or a 401(k) at a new employer. Doing a rollover allows you to skip paying tax and keep your money growing for the future.
In part 2 of this series, we’ll cover 3 more types of tax-advantaged accounts that you can use to grow a healthy nest egg for retirement.
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