Your Retirement Account Options – Part 4
As we have previously learned setting yourself up for a successful retirement can be boiled down to consistently funding a retirement account over a long period of time. This is honestly 80% of the work but for some reason, most people refuse to do it. You aren’t like most people though and you have decided that now is the time for you to start planning for retirement.
You already know why you need to start and you should have a good idea of a goal for your account. The next logical step is to start an account, right? While you are correct there is a step in between that you must take into consideration. Which is choosing the right type of account. That’s right there are many different versions of retirement accounts, each with their own pros and cons. Using the right type of account and knowing why is the other 20% of the work that most people never get to. Again, you aren’t like most people though so here are your options for a retirement account.
401(k) & 403(b)
The most common type of retirement account that you probably have access to is a 401(k) or a 403(b) if you work for a public school. Each employer operates differently but typically they give you a set list of investments that cover a wide spectrum of funds. These could be simple index funds or more complex mutual funds; what you invest in depends on what amount of risk you want to take.
It’s important to note that the money for this account is pre-tax. This means that it is taken out of your gross pay. However, when you withdraw it down the road you will have to pay taxes. Moreover, you can choose exactly how much of your paycheck you want to contribute. There is a limit of $18,500 per year though.
One of the biggest benefits of an employer-sponsored 401(k) or 403(b) plan is their ability to match. For example, when you contribute 5% of your paycheck your employer will match this dollar for dollar. That’s free money! Of course, these numbers all depend on your employer and their plan, but I’ve heard of matching rates upward of 6.5%. If you aren’t contributing to at least receive the match then you might as well be throwing money away. It amazes me how many people don’t take advantage of this.
If you are lucky enough to have an employer match program that doesn’t necessarily mean you should only contribute that specific percentage. Personally, I would suggest somewhere between 10%-15% of your gross pay. After 6 months of contributing at this higher rate, your lifestyle will adjust, and you won’t even know it’s coming out of your paycheck.
A traditional IRA is very similar to a 401(k) or 403(b) in the fact that you are investing before tax money. Unlike an employer-sponsored plan, the max you can contribute is $5,500 per year. There is no income cap on traditional IRA’s like you’ll see later with Roth IRA’s. But in some cases, you won’t be able to deduct your contributions from your taxable income.
If you have a single income greater than $62,000 or a joint income greater than $99,000, you may not be eligible. There are special cases that depend on whether you or a spouse have an employer-sponsored retirement account but that is out of the scope of this article.
Unlike a 401(k) or traditional IRA, a Roth IRA allows you to deposit after-tax money. The advantage of this is that when you withdraw this money when you retire you don’t have to pay any taxes on gains you made while that money was invested. The downside is you must wait till you are 59 ½ before you can start to pull your money out. If you choose to do it before then you will pay a hefty tax penalty. You can, however, pull out the principal, or the amount you invested. My suggestion is to never do this though unless it is an absolute emergency as you will kill the compounding effect of that money that we talked about earlier.
Like the other retirement accounts, there are certain limits on a Roth IRA. You must have an adjusted gross income that is less than $116,000, or $183,000 if you are filing jointly. Along with that, you can only contribute $5,500 of after-tax money per year.
Health Savings Account
The last account type I want to mention is a Health Savings Account. This is not a retirement account but once you turn 65 it can turn into one. An HSA allows you to contribute before-tax funds to an account just for spending on medical expenses. If you are single you can contribute up to $3,450 and if you have a family $6,900 (as of 2018).
These funds will then earn interest which is again, not taxable. The best part is if you don’t spend the money that year it will roll over into the next. This can build quite the nest egg over time. When you turn 65 you can then withdraw this money as if it was a traditional IRA. You will be taxed on the money when you withdraw it but you still have accumulated years of interest.
Let’s not forget that the primary reason for this type of account is to pay off medical expenses. There is a set list of medical expenses you can spend this account on that you can find here. I’ll save you the read though if you aren’t that interested. Anything from ER visits, eyeglasses, and even therapy are all covered.
The last thing you need to know is that you must qualify for this type of account. If you have health insurance through your employer you most likely will not qualify. The point of this account is to ease the medical burden for people who have high deductible health insurance. I won’t go fully into health insurance here but if you want to learn more check out HealthCare.gov.
The bottom line is this can be a useful way to take out two birds with one stone. At the very minimum, you are preparing for a medical emergency with a potential positive side effect of having a retirement nest egg.
Wrapping it Up
How you choose to structure your accounts is a personal decision. At the very minimum if you have a 401(k) match program at your company you NEED to be participating in it. After that I always recommend people open up a Roth IRA. Reason being is I want to pay my taxes now so when I retire I can withdraw my money and not worry about it. In other words, I believe my tax rate now will be lower than it will be when I’m 59.
Lastly, if you have a 401(k) your employer will run it through a provider. These will differ from company to company, but some common ones are Vanguard, Principal, and Fidelity Investments. The reason I bring this up is that these same companies offer all the products listed above. Instead of hunting the internet looking for the top 10 of 2018 and trying to learn a whole new platform just keep it simple and stick with what you know. Go to that company’s website and look up their products, sign up for one, connect your checking account, and start a monthly automatic transfer if your budget allows. It is really that easy.
In the coming weeks, I’ll show you how to actually open up an account if you don’t already have one. We will also debunk some common myths around retirement and learn how to automate your contributions to the point where you won’t even realize it’s happening.
If you happened to miss any of the previous week’s articles in the retirement series then check them out below.