One of the most critical yet confusing aspects of personal finance is saving for retirement. Individuals have a number of different options for saving, and it can become difficult to decide which avenue is the best. Many people do not even realize all the different options that exist and tend to stick primarily with the retirement savings accounts offered through their employers. However, it’s often a good idea for individuals to supplement their savings with other types of accounts to diversify their approach and take advantage of various tax benefits.
The most basic retirement savings account is a 401(k), which remains the best place to start for the majority of savers. Money for this account comes straight from an employee’s payroll deductions before companies take out taxes. Often, employers match all or part of an employee’s contributions. However, restrictions and limits do apply, so it might become necessary to open other accounts. Importantly, money that a person places into a 401(k) is taxed at the time of withdrawal because its contributions come from pre-tax earnings. The equivalent of a 401(k) for nonprofit workers is a 403(b), which functions in much the same way.
Some of the other investment options individuals may want to consider include the following:
The major advantage of a Roth individual retirement account (IRA) is the fact that money grows in the account tax-free. Because the government has already taxed all of the money that a person deposits into this type of account, individuals will not have to pay any taxes when they withdraw the money during retirement.
With tax laws and regulations constantly changing, taxes can prove unpredictable. One good way to remove some of the unpredictability of retirement planning is to invest in a Roth IRA, which does not carry a future tax burden. In a sense, opening a Roth IRA in addition to a 401(k) hedges one’s bets in terms of a person’s tax situation. People pay taxes on both 401(k) and traditional IRA withdrawals, as well as on Social Security payouts in some cases, and having tax-free income from a Roth IRA can help individuals avoid getting pushed into a higher tax bracket. In fact, those who only withdraw Roth IRA distributions can avoid paying Social Security payout taxes altogether because this obligation is based on taxable income during retirement.
The other major benefit of a Roth IRA is flexibility. Individuals can pull out money at any time without taxes or penalties, unlike with other retirement accounts, although taxes and penalties do apply to investment earnings in the account. While individuals should not treat Roth IRAs like a savings account, they can be a useful contingency plan when emergencies arise, or in the event of long-term unemployment.
A health savings account (HSA) is an account coupled with a health insurance plan that has high deductibles. The HSA allows individuals to save money for medical expenses in the account. What makes the account so special is the three-fold tax advantage that it provides in the context of retirement.
With an HSA, individuals can get tax breaks with both contributions and distributions because the dividends, interest, and capital gains earned with the account are not taxed and money goes into the account before being taxed as income. While working, people can only use the money in this account for specific, qualified medical expenses. However, after individuals turn 65, they can use the money for whatever they would like. Thus, an HSA both minimizes healthcare costs while serving as an excellent retirement account.
Limits to how much individuals can put into the account exist, but they increase after age 55 and leftover money rolls over each year. With this account, retirees need to read the fine print to make the most of tax advantages. During retirement, using the money for non-medical purposes may incur taxes, but people can use withdrawn funds to “reimburse” themselves for expenses paid years in the past as long as they have valid receipts.
Solo 401(k) and SEP IRA
While the solo 401(k) and simplified employee pension (SEP) IRA are very different accounts, they get grouped together because they are the primary retirement savings options for self-employed individuals. People who are sole proprietors can set up a solo 401(k) that allows them to make contributions as both the employer and the employee up to a certain limit. A SEP IRA is ideal for both self-employed individuals and small-business owners. Employers can contribute up to a quarter of their income, up to a specific amount, and the accounts are simpler to create than solo 401(k)s. For small businesses, employers must contribute to employee accounts for qualified individuals. Another option for small-business owners is the simple IRA, which involves less paperwork but requires employers to make a matched or unmatched contribution for employees.
People who have a 401(k) through their main employer but also have a side gig can generally qualify for a SEP IRA, which offers another avenue for greater savings, especially because the upper limits on these accounts far exceed those of other retirement savings accounts, especially because they can make contributions as both employer and employee. Theoretically, individuals can max out contributions to both Roth and SEP IRAs at the same time, unlike traditional and Roth IRAS, which have a shared annual contribution limit.