I commonly get the question of how investing in retirement accounts can impact your taxes. There are so many options and each has its own limitations and requirements, that it can be confusing for anyone. First- let me remind you that I am not a financial planner, but I am a tax attorney. Next, your mileage may vary. Now, you may either need to do some specific research into your own situation and plan or may need to hire a professional tax preparer to see the biggest tax benefit from using these potential deductions. Got it? OK.
Retirement accounts are generally tax-deferred accounts, meaning that the money you put aside now (pre-tax) grows tax free, and you only pay tax on money as you withdraw it or receive distributions. This is a great way to plan for retirement from a young age, as it lets you set aside money now, effectively reducing your taxable income now, and then use it later, when you are likely going to be in a smaller tax bracket since you are expected to have a smaller “income” when you retire. The numbers for the plan are short-hand, usually based on the law that the authority to create this type of tax-savings plan comes from. As long as you know what your particular plan entails and any requirements you have to meet, you won’t usually need to go back to the source material and read the underlying law.
As with many things, the earlier in life you start planning and saving for retirement, the better off you are going to be. People who really like numbers can go through the different formulas and see the interest-based growth over time. My eyes start to glaze over when you start talking compound versus simple interest, and expected rates of return. But I know the bottom line there is basically to get started. Wherever you are in life- start saving NOW. Even if you can only start with $50 per month or per paycheck, you will be in a better place when you are looking at your impending retirement than if you don’t start planning for it. And even if you CAN theoretically borrow against this account (such as to buy a home, for medical bills, etc. or just for other life stuff), really think hard before doing so. These accounts are designed to help you in retirement. Use a savings account for the short term expenses that come up long before touching the retirement account.
Savings account or CDs
Many folks don’t think in terms of retirement when they think about savings accounts or CDs. It is true that this is not going to be a fast way to add money to a retirement account. Interest rates on savings accounts and CDs tend to be low, though they do get higher the more money you can commit to the account and/or the longer you can leave your money untouched in the account. This is a good slush fund, since you can access a savings account pretty much whenever you need to, and you can access your CD either at the end of the term with no penalty or anytime (usually with a penalty such as 3 months of interest earnings). Another big reason to use savings accounts or CDs for retirement is that there is no cap on the money you can deposit in a given year. So if you are one of the lucky few in the top earners and have the disposable income to do it, this may be a good option to consider. There are very few requirements to have a savings account or CD. You do need to pay taxes on any earnings over the year, so keep your 1099-INT forms. Check your local bank, credit union, or any of the banks on the internet for their current rates.
Remember the good old days when you worked for your employer for a long time, sometimes your entire working life, then when you retired, they paid you a pension each month? Me neither. I have heard of these, but think that by and large these are going the way of the dodo. I do remember pensions being the news, but that is mostly when the different pension plans were going bankrupt and people who had retired or who had been working on the theory that they would get the pension when they did retire were sorely out of luck. You may be a U/S/ military veteran, former government employee, or someone else who has a pension plan. If so, this is money that is set aside for you by your employer for when you are in retirement. This is paid generally in equal monthly allotments either for life, or until the terms of the pension are met.
401(k) (Profit Sharing Plan)
This is a retirement account established by your employer into which either you or your employer contribute money. Some employers have a match system where the employer will contribute to the 401(k) account based on employee contributions or a portion of employee contributions. Other employers have a profit sharing model where the employer contributes to all employees plans based on the current year profits. Some have stock options. Some do nothing. Some employers do not offer a 401(k) account, or only offer access after a certain amount of time with the employer or to certain classes of employees (such as full-time or permanent hires rather than part-time or temporary/seasonal).
Funds going into a 401(k) account are tax-deferred. There is a yearly limit, currently $16,500, on a 401(k) account. If you are age 50 or older, you may also make a “catch up” contribution to your 401(k) of up to an additional $5,500. This is a per person limit, so each spouse can contribute to their own 401(k), if applicable, but both spouses cannot contribute to one of the spouse’s account.
If you do have an employer match program available to you, look carefully before deciding how much you want to contribute. If you don’t contribute the maximum that your employer will match, you are essentially throwing away a raise. Of course, since that raise is only really there once you access your 401K account, it might be necessary to plan for the here and now rather then the “hopefully someday when…” In other words, try to manage your finances so that you can contribute at least as much as will be matched by your employer, but don’t do so at the expense of high interest credit cards or other debts NOW.
403(b) (Tax Sheltered Annuity)
This is another pre-tax voluntary contribution retirement account. Usually non-profit employers, such as hospitals, museums, churches, or schools will have this kind of plan. There is no further tax advantage on the tax return, since the contributions are made pre-tax, and therefore are only taxed when accessed.
IRA (Individual Retirement Account)
IRA contributions are generally limited to $5000 per signer on the tax return, or $6000 if the contributing person is over age 50 by the end of the calendar year.
Traditional- Anyone can contribute to a Traditional IRS, so long as you have the income to do so. This is linked to your name and social security number, and each person has to have their own. So, each spouse can contribute to their own IRA. Even a teen with a part-time job can open an IRA and contribute up to what they make that year. Wikipedia has a good chart of the advantages and disadvantages, here. Depending on your household income, you may or may not get a tax advantage to contributing to an IRA.
Roth- This one doesn’t give you a tax deduction when you put money in, BUT, when you take your money out, IF you meet all the requirements, ALL of your earnings are tax free. Think of it this way: since you are putting post-tax money in this account, the only thing left to be taxed is the interest earned on the money you put in over time. It is kind of like a designated retirement savings account, with special rewards for leaving your money in until you actually retire. Another benefit is that you are not forced to take minimum distributions after age 70 ½. And you don’t have to pay an early distribution penalty if you do have to access your money before you are age 59 ½.
SIMPLE- This “Savings Incentive Match Plan for Employees IRA” is funded by pre-tax salary contributions, much like a 401(k). You do pay social security and medicare tax on these funds, but don’t pay federal income tax when you have the money set aside in the SIMPLE. SIMPLES don’t differ much form the other plans, but are designed for employers with less than 100 employees total. The contribution limit is also lower than the 401(k), at $11,500 for the 2011 year, with the possible catch-up contribution of $2,500 for those ages 50 and over. There is an early withdrawal penalty of 25% of the distribution if you take the money within 2 years of the date of the first contribution to the account and/or if you are under 59 1/2 when you get the distribution. Ouch- that can hurt.
Please note: There are penalties and additional taxes that can apply with each different type of retirement account if you contribute too much money in a given year, don’t meet the requirements for the program, withdraw your money before you turn 59 ½, fail to start withdrawing your money by the time you turn 70 ½, or other considerations. Make sure that you clearly understand what type of retirement account(s) you are contributing to. And then make sure that either you follow all of the rules or that you have someone managing your money that can make you follow the rules for your particular program.
With different options available, you should do your research to make sure that you are meeting your best tax advantages and planning for a retirement that addresses your particular needs and financial situation. You may have money in multiple types of accounts. You may be starting late, or be unable to contribute as much as you would like to right now. You may inherit funds from a retirement account of a loved one (which can be rolled into your own retirement profile). I suggest reviewing all options with a financial planner before opening any of the retirement accounts. But first- have some idea of what you may be looking for by comparing the different options. I appreciate the Wikipedia comparison chart myself. Or, for another comparison and some examples of which type of retirement accounts to fund check out Charles Schwab.
And PLEASE PLEASE PLEASE talk to someone before you try to cash out, roll over, transfer, borrow from, or otherwise access or change your existing retirement accounts. The penalties and rules vary with different programs and accounts. In short, doing it “wrong” could cost you a lot of hassle, stress, and money. Conversely, planning ahead, starting early, and making voluntary contributions to your retirement could not only set you in better financial standing when and if you choose to retire, but could also save you on your taxes now.