The retirement landscape has shifted in the United States. Gone are the days of the defined-benefit pension plan that saw employees rewarded for their many years of loyal service with a steady stream of checks in retirement. Now, the responsibility of saving for retirement rests on your shoulders. The question is, are you effectively utilizing all the accounts at your disposal?
Everyone deserves to enjoy a comfortable retirement after a long career, but getting there takes discipline and careful planning. With costs rising and life expectancies increasing each year, retirement is becoming more costly. Among the expenses to consider are housing, healthcare, leisure activities, and taxes.
While most taxpayers will qualify for Social Security, those benefits may only account for a fraction of what you need. Luckily, there are many retirement plans available that can make saving for the next phase of your life less daunting. Let’s take a look at some of the more popular options.
The Individual Retirement Account (IRA)
An individual retirement account (IRA) is a tax-advantaged investment account that’s meant to make it easier for Americans to save money for retirement. IRAs generally afford superior flexibility and access to a broader range of investments when compared to other popular accounts like the popular 401(k) but at the cost of lower contribution limits. A variety of different IRAs exist, and each comes with its own set of tax and regulatory implications. The one you choose will likely depend on your employment circumstances and how much you earn. Let’s break down some of the most common types below.
Traditional IRA
The most common type of IRA, the traditional IRA, is available to anyone who earns income within the calendar year they wish to contribute to one. The account is funded with pre-tax dollars and contributions can be invested within the account on a taxdeferred basis. What it means to be tax-deferred is that your account’s earnings (interest and capital gains) are not taxed until you withdraw them, at which point they’re treated as ordinary taxable income. This treatment essentially allows you to kick your income tax burden down the road.
IRA owners are able to invest in almost any asset they choose to, from stocks, bonds, and mutual funds to ETFs and real estate. Another benefit of the traditional IRA is that you can receive a tax deduction for your pre-tax contributions, thus lowering your total taxable income. The annual contribution limit for traditional IRAs is $6,000, or $7,000 if you’re over 50 and qualify for catch-up contributions.
Roth IRA
The Roth IRA is similar to the traditional IRA in terms of which investments you’re able to hold within it, but it differs in terms of how it’s taxed and how you can access your contributions. Roth IRAs are funded with after-tax dollars and the investments within these accounts are allowed to grow tax-free. This means that withdrawals after the retirement age of 59½ occur without having to pay income taxes or other penalties.
Another benefit of the Roth IRA is that you can withdraw contributions (but not the earnings on those contributions) to make important purchases or cover qualifying expenses like college tuition. However, Roth contributions don’t entitle you to a tax deduction, since you’ve already paid income taxes on the money you’ve contributed. The annual contribution limit for Roth IRAs is $6,000 (or $7,000 if you’re over 50) and total combined contributions to Roth and traditional IRAs cannot exceed this figure. Roth IRA contributions are subject to a phase-out of income, meaning if your income is above; $129,000 to $144,000 (single taxpayers and heads of household), $204,000 to $214,000 (married, filing jointly), and $0 to $10,000 (married, filing separately) then you cannot contribute. If this is the case, you should explore if a Backdoor Roth IRA contribution could be a solution for you. For more on a Backdoor Roth IRA refer to a previous article we wrote in early 2022.
SIMPLE or SEP IRA
SIMPLE and SEP IRAs exist to fulfill the retirement-saving needs of small business owners and self-employed individuals, respectively.
If you run a small business, the Savings Incentive Match Plan for Employees (SIMPLE) IRA can help you create a retirement plan for yourself and up to 100 workers. You’ll be required to match your employees’ contributions up to 3% and make a 2% nonelective contribution for all eligible employees each year. The annual limit allows for $14,000 in contributions if you’re under 50 and $17,000 if you’re over 50. SIMPLE IRAs are taxed upon withdrawal, and there’s a costly 25% penalty for any withdrawals made within two years of opening the account.
In the case of the Simplified Employee Pension (SEP) IRA, all contributions are made on behalf of your employer, and the annual limit for 2022 is the lesser of $61,000 or 25% of your compensation. There’s also no Roth option, so any withdrawals in retirement will be taxable as income.
The 401(k)
The employer-sponsored 401(k) is the most widely used workplace retirement planning tool. These plans are established to encourage employees to save for their retirements and they provide exclusive tax benefits that make it easier to do so. Contributions can be made with pre-tax or post-tax dollars and can be invested in securities like stocks, bonds, and mutual funds.
One of the most appealing features of the 401(k) is the ability for your employer to match a portion of each of your contributions. Your employer might offer to match your contributions up to a certain percentage of your salary, for instance, 5%. Employer contribution matches can help increase the amount you’re contributing each period without costing you any extra money. Keep in mind all employer contributions will be made with pre-tax dollars and will be taxed as income when distributed.
Most 401(k) plans allow both pre-tax and Roth contributions. If you anticipate your income tax rate being higher in retirement than it is now, the Roth might be the wiser option for you. Conversely, if you would benefit from lowering your taxable income today by way of deduction, the traditional 401(k) might better suit your needs. The annual individual contribution limit for 401(k)s is $20,500, or $27,000 for those older than 50 in 2022. This limit applies only to the funds you contribute yourself; it doesn’t include whatever your employer decides to contribute on your behalf.
Solo 401(k)
Whether you’re a self-employed worker or you own a small business with your spouse, a Solo 401(k) offers a tax-advantaged way to save for retirement. With a Solo 401(k), you play the role of both employee and employer, which means you can make contributions for yourself and on behalf of your company. This plan brings with it a relatively high annual contribution limit of $61,000, or $67,500 if you’re old enough to qualify for catch-up contributions. Similar to a standard 401(k), the owner can choose between a opening traditional or Roth account. That way, you can either defer taxes to save money right now or receive tax-free money during retirement.
Health Savings Account (HSA)
Health savings accounts (HSAs) aren’t technically retirement accounts, but they can still prove invaluable in the pursuit of your retirement goals. The primary function of an HSA is to help people save for healthcare expenses by providing tax-advantaged growth for the investments within the account. They are known as Triple Tax Free as the funds committed to the account are tax-deductible and then grow tax-free until you need to withdraw them to cover medical costs. Withdrawals can be made at any time and are also tax-free–so long as they’re used to pay for a qualifying healthcare expense.
Fidelity projects that the average 65-year-old couple in America will need to spend approximately $300,000 on medical care over the course of their retirements, and it’s likely that we’ll see this number continue to rise. Investing in an HSA could go a long way toward lessening the financial burden of future medical expenses, and it’s the most tax-efficient vehicle for healthcare savings. For many individuals with strong cash flow, a great planning strategy is to fully fund the HSA but NOT use it for current medical expenses. This allows the HSA the ability to grow and compound tax-free for use later in life when medical expenses will likely be larger! But the benefits don’t stop there. Once you turn 65, you can use your HSA funds however you’d like—not solely on medical costs—without having to pay a penalty or fee. However, you’re still required to pay income taxes on your distributions as you would with a tax-deferred investment account like a traditional IRA. The annual contribution limit for HSAs is $3,600 for individuals and $7,200 for families.
Taxable Brokerage Account
If none of these plans sound appealing to you, or if none is sufficient to meet your retirement planning needs on its own, there’s always a taxable brokerage account. Many opt for a brokerage in addition to their tax-advantaged retirement account in order to save more or enjoy greater flexibility with their investments. Bear in mind that these accounts aren’t afforded any of the special tax breaks as the retirement accounts discussed previously, and you must pay capital gains taxes on any income you earn. They can, however, be an integral part of a retirement income strategy that pairs retirement account withdrawals which are taxed as income (unless Roth) withwithdrawals from a taxable brokerage account where the tax would only be on realized gains and that tax can be as low as 0.
Final thoughts
Remember that the contribution limits for IRAs, 401(k)s, and HSAs are independent of one another, so there’s nothing keeping you from investing in more than one of these accounts at once if you choose to. In fact, many find that some combination of the above savings plans can better suit their needs.
No matter which account, or accounts, you use in your retirement plan, consider making contributions as often as possible. It can be difficult to set aside money from each paycheck, especially early on in your career, but small investments today can add up to a more substantial sum by the time you’re ready to retire. This is the power of compound interest. Take this example – a Roth IRA funded with a yearly $6,000 contribution for 30 years with yearly growth of 8% would be valued at over $740,000!
If you’re interested in discussing your retirement saving options, reach out to a Financial Planner at Ausperity Private Wealth.
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