In past articles, we’ve looked at how much you should save for retirement and how to budget those savings. For this post, we’ll show you the best ways to reach your retirement savings goals through five different retirement plans.
Depending on where you stash your cash, there are a variety of tax incentives that benefit different types of savers. Knowing the subtle differences will ensure that your money grows at a solid rate and that you won’t get hit with a surprise gut punch of a tax bill come retirement time.
Read on to find the assortment of retirement plans to plant your savings to get the best growth.
1. 401(k) and 403(b) Retirement Plans
Employer-based retirement plans such as a 401(k) and 403(b) are some of the best and most common ways to save for retirement in the US. According to Pew Charitable Trusts, about 49% of all private sector employees participate in an employer-provided retirement plan, while 58% of workers have access to such a plan.
For both 401(k) and 403(b) retirement plans, employees designate a percentage of their paycheck to invest toward their retirement. A brokerage company uses this money to invest in mutual funds, annuities and other relatively safe investments. Because you contribute pre-tax income, it takes a smaller bite out of your paycheck than you might expect. For example, if you contribute $100 each month, your paycheck will only be lowered about $60 to $80 for the month, depending on your salary and tax bracket.
What’s the difference?
You have probably at least come across a mention of a 401(k), but 403(b) retirement plans might be a new term. Basically, both accounts work the same way, with employers setting aside a specified amount of pre-tax income toward the investment. However, 403(b) retirement plans are only available to employees working at nonprofit institutions such as schools, hospitals and charities.
Tax advantages and rules
Contributions to a 401(k) or 403(b) plan are tax deductible, which results in a lower overall tax bill at the end of the year. Your contributions remain tax-free and grow with the help of compound interest until you start withdrawing money, which you will then have to pay standard income tax. You can begin withdrawing at age 59 ½. If you need to pull out your money early, then you’ll be subject to a 10% tax penalty from the IRS, so make sure the early withdrawal is absolutely necessary.
Both 401(k) and 403(b) plans allow you to contribute up to $17,500 each year. If you’re over the age of 50, then you’re allowed an extra $5,500 to contribute, for a total of $23,000 per year.
2. IRA and Roth IRA Retirement Plans
An Individual Retirement Account, or IRA, is a great savings option for those who either don’t have access to an employer plan or have already contributed the maximum amount. Like a 401(k) plan, your IRA contributions grow tax-free during your working years and can be deducted from your tax bill. However, if you combine a 401(k) with an IRA, then you can’t deduct contributions if you earn above above $71,000 for the year (or $118,000 for joint filers).
On a traditional IRA, you will have to pay regular income taxes once you begin making withdrawals. Conversely, Roth IRA contributions cannot be deducted during your working years, but you won’t have to pay taxes on withdrawals.
You can contribute up to $5,500 per year to both an IRA and Roth IRA plan. If you’re over 50, then you’re allowed a catch-up amount of $6,500. You can withdraw your money at age 59 ½ without penalty. If you withdraw early, then the IRS will hit you with a 10% penalty, so it’s best to let your savings ripen unless you really need it.
For traditional IRA plans, you will need to make mandatory withdrawals at age 70. However, Roth IRAs don’t have this requirement.
Click here for more information about which type of IRA is best for you.
3. myRA Retirement Plans
myRA plans are the newest of the bunch, as the Obama administration rolled out the program in late 2015. These accounts target low-income earners who don’t have access to an employer plan and don’t have enough money to start an IRA.
You can start a myRA plan for just $25 and your contributions can be as little as $5 per month. There is no cost to set up a myRA and the government secures your money. When your myRA account hits $15,000 or 30 years of age (whichever comes first), the money automatically transfers into a private traditional or Roth IRA account.
Essentially, your money is invested into a Treasury security, which delivers modest, but regular returns. Some retirement advisors caution that the returns are lower than private retirement accounts, but most say that a myRA plan is better than nothing. According to the financial website Motley Fool, myRA plans normally have a 2-3% return rate, versus an average 10% return for the S&P 500. But a myRA plan is perfect for those looking for a starter account with little risk.
4. Deferred Annuities
If you’ve maxed out contributions on your 401(k) and your IRA plans, then congratulations for being a super saver. Fortunately, you have more options to further your savings. A deferred annuity offers you similar perks and tax benefits of 401(k) and IRA plans. Like those plans, you’re able to withdraw money from the annuity at age 59 ½ without penalty, or else you’re subject to a 10% tax penalty.
But annuities differ from other retirement plans in that you can actively make tax-free exchanges between various investment portfolios. This makes annuities an attractive option for those wanting to take more control in their investment decisions, but want a safer route than risking everything on the stock market.
Deferred variable annuities offer flexible rates of return, depending on the specific investment portfolio you decide upon. In contrast, fixed deferred annuities offer a set rate of return in exchange for keeping your money parked for a set period of time before you can exchange portfolios. This time period usually runs about three to seven years.
5. Health Savings Accounts (HSA)
The last savings vehicle we’ll discuss is the Health Savings Account, or HSA. As the name implies, these accounts focus on saving for healthcare-related expenses. As healthcare costs continue to skyrocket, opening an HSA can be a powerful weapon to shield you against future expenses.
Rules and tax benefits
HSA contributions help pay for insurance deductibles and qualified medical expenses, including those not covered by health insurance. You are able to contribute $3,350 per year for an individual and $6,750 for a family. For those 55 and over, you’re allowed to save an extra $1,000 per year. If you don’t use all of the funds in a given year, then the money rolls over and continues to grow. This differs from a Flexible Spending Account (FSA), which requires that you spend the entire balance or lose it at the end of the year.
The tax benefits under an HSA are similar to other retirement accounts in that your contributions are tax deductible. This lowers your taxable income while your money grows tax-free. Your withdrawals also won’t be taxed, as long as you use your HSA savings for health-related reasons. However, if you use the money for expenses that aren’t health-related, then you’ll be hit with a 20% tax penalty.
Here’s one caveat on HSA plans: The account must be paired with a high deductible insurance plan with a deductible of at least $1,300 for individuals ($2,600 for a family). High deductible plans generally target young, healthy people, so an HSA isn’t ideal for those with high medical expenses.
These are just some of the ways that you can beat the taxman and grow your savings for the future. The earlier you start, the more gold you’ll have waiting for you at the end of the employment rainbow.
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