Here's the 411 on 401(k)s—and other types of retirement plans
Plus, what to do when you've met your company match
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Whether you expect to retire in a few years or decades from now, it’s important to get into the habit of saving for this stage of your life. Retirement experts generally recommend stashing away at least 15% of your earnings per year throughout your career.
You don’t have to max out your budget if you can’t afford to save that much yet. Simply getting started—and then increasing your contributions over time—can help get your savings strategy on track. In a recent poll, surveyed millennials started saving for retirement at age 24 on average, and about a quarter of people in this age group now have $100,000 or more set aside.
Taking advantage of a workplace retirement plan can help, and self-employed folks have options, too. Here’s a quick overview of which retirement accounts you might use and who they’re best suited for.
Roth versus traditional
Before we dive in, it’s good to understand the difference between “Roth” and “traditional” accounts. You might have a choice between these variations, such as a traditional 401(k) versus a Roth 401(k). The key difference between the two types of accounts is when you pay tax.
- With a traditional account, you deduct contributions now and pay taxes on withdrawals later (usually in retirement).
- With a Roth account, you pay taxes on contributions now and withdraw the money later tax-free.
“The rule of thumb is: If you expect your tax rate to be higher today than at the time of withdrawal, go with a traditional account,” says R.J. Weiss, a certified financial planner and founder of The Ways to Wealth. “If you feel your tax rate will be lower today than at the time of withdrawal, use a Roth.”
Start here if you work for a company that matches contributions
A 401(k) is a retirement plan that’s usually offered by for-profit companies (and some nonprofits). You can usually sign up anytime by filling out a form and telling your employer how much to withdraw from your paycheck. It will deposit that amount with a company, such as Fidelity or Vanguard, that invests it in conservative, middle, or high-risk investments.
If your employer offers one, it may match your savings as part of your benefits package. For example, it may match everything you save, up to 3% of your salary. This is free money, so make sure you take advantage of the offer.
The government limits how much you can save in tax-advantaged retirement accounts, but the amount usually increases each year. For 2021, the most you can stash in a 401(k) is $19,500. (The 2020 limit was $19,000.)
The government also gives you a chance to “catch up” on contributions if you’re older and your nest egg has some growing to do. If you’re at least 50, you can save up to $26,000 per year in a 401(k). These limits include your contribution and your employer’s match combined.
A bit of advice from a pro: “Contribute at least up to your employer match in your 401(k) or 403(b) before considering other retirement accounts, such as an IRA or HSA,” Weiss says. Additionally, “you’ll want to watch out for fees, which tend to run higher in employer-sponsored plans.”
For anyone who works at a nonprofit that matches contributions
403(b) accounts are offered by certain nonprofits, such as public schools, local governments, hospitals, and other tax-exempt organizations. They’re similar to a 401(k): You defer a portion of your pay into the account and won’t pay income tax on the savings until the money is later withdrawn.
Contribution limits are fairly high for 403(b) accounts. In 2021, you may set aside up to $58,000 or 100% of your most recent yearly salary, whichever is less. The catch-up contribution limit depends on how long you’ve been with the company and a few other factors.
Enrollees typically have fewer investment options compared to other types of retirement accounts. So if you’re looking for more variation in your portfolio, consider contributing up to the amount your employer matches in your 403(b) and then opening an IRA.
An option for those who are self-employed, don’t have access to a company-sponsored plan, or want to contribute beyond an employer’s plan
Individual retirement accounts (IRAs) are available at financial-services firms like big banks and brokerages. Compared to other retirement plans, IRAs provide a much larger selection of investment options. You can usually choose individual stocks or mutual funds, or allow the company to make those decisions for you.
Once you contribute money into the account (up to $6,000 in 2021, or $7,000 if you’re 50 or older), it’s tax-deductible on both state and federal tax returns for the year you make the contribution. The earnings grow tax-deferred until you withdraw them in retirement.
Your traditional IRA contributions will generally lower your taxable income in the year you make the contribution. That lowers your adjusted gross income, which could help you qualify for other tax incentives you wouldn’t otherwise get.
If you’re looking to stash away more than the annual limit, talk with a financial planner about other ways to invest. “Using a buy-hold approach to investing is still very tax-friendly,” Weiss says. “Many robo-advisors and investment brokers even have low-fee, tax-friendly funds that can minimize your tax burden further.”
Calling all small business owners
Ready for some alphabet soup? “SEP IRA” stands for simplified employee pension (SEP) individual retirement account (IRA). These are similar to traditional IRAs: You direct earnings into a tax-advantaged retirement account, invest the money, and pay taxes when you withdraw the money later.
SEP IRAs come with a few major caveats. According to the IRS, you must contribute to a SEP IRA for every eligible employee—and the contribution percentages must match. So if you contribute 10% of your own earnings to a SEP IRA, you must contribute 10% to every eligible employee’s account, too. What’s more, there’s no Roth or catch-up contribution available.
But for many small business owners, the big draw is the high savings limit. In 2021, you can contribute up to $58,000 or 25% of the employee’s compensation, whichever is less.
Sole proprietors who have no employees—this is for you
This type of 401(k) is for entrepreneurs who don’t have any employees (except a spouse) and want to set aside money beyond the low IRA limits. You can contribute to the plan in two ways:
- As the employee, contribute up to $19,500 or 100% of your earnings per year, whichever is less.
- As the employer, contribute up to 25% of your compensation.
For example, let’s say you’re a freelance graphic designer with no employees and you earned $100,000 last year. You can first contribute up to $19,500 as an employee, then another $25,000 as the employer. In total, you could set aside $44,500 every year to help build your retirement nest egg.
A self-employed 401(k) might also make you eligible for additional tax breaks. Depending on how your business is set up, you may be able to deduct your contributions or count them as a business expense.
Make sure you’re meeting your other goals
While it’s critical to save for retirement, Weiss says it’s just as important to address your other financial goals. For example, you might want to pay down high-interest debt and create an emergency fund while contributing only a small amount toward retirement. Then, you can steadily increase your contributions once your finances are stable.