At some point, most of us realize that we need to start saving for retirement. For some, it comes from the struggle of a parent or grandparent trying to make ends meet on social security alone. For others, it comes from the vision of a great retirement or even early retirement. Either way, saving for retirement is an integral part of almost everyone’s financial journey.

However, the process of actually saving for retirement is not that clear. There are many ways for most people to save for retirement. Virtually all Americans have access to traditional IRAs, and most Americans also have access to a Roth IRA. Many Americans also have company pension plans, and there is always the option to simply put your money in an ordinary investment account.

How does a person navigate these options? What is the difference between them Let’s dive in.

It’s the taxes!

Almost all retirement accounts for individual savers have some things in common. You are depositing money from anywhere, either directly from your paycheck or checking account, and you usually consent to it being done automatically and on a regular basis. You choose investment options for that money. Then it sits there until you need it in retirement (or during a major financial crisis).

The big difference between the different retirement account options is taxes. Here is how.

Taxes on a normal investment account

Investment accounts are set up directly with an investment firm such as Fidelity, Vanguard, Charles Schwab or Edward Jones. In a normal investment account, you deposit money directly from your current or savings account. Remember, money in your checking or savings account is money that you have already paid (or will soon be paying) income taxes on. Once the money is in an investment account, you decide how it will be invested: stocks, bonds, index funds, whatever you want.

As long as you leave it alone and let it grow without selling it, you don’t owe any taxes on that investment. However, it can generate income for you in some way, such as dividends. You owe taxes on dividends and other income in the year you earn them.

When you sell an investment in a regular investment account, you owe taxes on how much you made from the sale. So if you originally bought an investment for $ 5,000 and sold it for $ 8,000, you owe income taxes on the $ 3,000 you made, even if you immediately invest it in something else. This is known as capital gain and is taxed at the current capital gain tax rate. As of 2020, short-term capital gains (investments that you have held for less than a year) will be taxed at a normal income rate, while long-term capital gains will be taxed at a lower tax rate.

  • Advantages: Quite simply, no requirements, you pay lower taxes on investments you hold for more than a year
  • Disadvantage: Dividends and other income are taxed as you earn them, with no other tax breaks

Taxes in a traditional 401 (k) / 403 (b)

For many people, the easiest retirement option is a company retirement account, usually called a 401 (k), 403 (b), or TSP. These plans work similarly.

With this type of account, money is deducted from your paycheck In front Taxes. This means your taxable income decreases for the year if you use this type of retirement plan. You bring home a smaller paycheck (because some of it goes straight to your retirement account) but the reduction in your paycheck is less than the amount you contribute (because you owe less tax this year). Some employers actually adjust your contributions up to a certain amount by instantly adding 50% to your money or even doubling your money.

Once the money is in the account, it will be deposited according to your instructions when you set up the account. If investments in your account generate income, it will stay in the account and be reinvested as per your instructions and You don’t owe any taxes on this money. The only time you owe tax on a traditional 401 (k) or 403 (b) account is when you withdraw money.

If you withdraw money from this account in retirement, it will be treated like regular income and taxed as if seeing if it was a regular paycheck. Typically, taxes are withheld when you withdraw the money to make it easy to file your taxes at the end of the year. The advantage is that in retirement your income level is usually lower, so the tax amount is much lower.

The premium limit for 401 (k) and 403 (b) is quite high at $ 19,500, with an additional make-up cost of $ 6,500 if you are 50 or older.

  • Advantages: The easiest option for those who have it, you can rebalance without tax worries, your retirement tax rate is likely to be much lower than it was during your career, your employer could match contributions
  • Disadvantage: Withdrawals are taxed as regular income; If you withdraw funds from the account before retirement, there may be an additional 10% penalty

Taxes in a traditional IRA

Another option to consider is a traditional IRA. You can set up a traditional IRA yourself with an investment firm. You deposit money from your checking account into the account and choose how it is invested. Once the money is in the account, you can buy and sell it however you want with no tax consequences, which means that you can restore the balance to your liking. Also, any income your investments might generate will remain in the account and will not be taxed until you withdraw them.

One advantage of a traditional IRA is that your contributions to it are tax deductible, provided you meet the income limit. So if you have individual deductions on your taxes (for most people this usually happens while paying off a mortgage), you may be able to deduct your traditional IRA contributions as well.

IRAs have an annual contribution limit. In 2021, that limit is $ 6,000 or $ 7,000 if you are 50 years of age or older. This is a limit over everything Your IRAs, traditional or Roth.

If you withdraw money from a traditional IRA in retirement, the withdrawn money will be taxed as normal income, just like withdrawals from a 401 (k) or 403 (b). However, as mentioned there, your taxable income level should be lower in retirement and therefore you will pay a low tax rate.

  • Advantages: Easy to set up, you can restore balance with no tax concerns. Your retirement tax rate is likely to be much lower than it was during your career. You may be able to deduct contributions in the year you made those contributions if you have enough other deductions
  • Disadvantage: Withdrawals are taxed as regular income; If you withdraw funds from the account before retirement, there may be an additional 10% penalty

Steering in a Roth IRA

A Roth IRA is similar to a traditional IRA with a few significant changes. Roth IRAs are available from most investment firms, and you can easily set one up yourself. As with a traditional IRA, you make contributions from your checking account. However, your contributions are not tax deductible, which only really matters if you have many other deductions anyway.

Once your money is in a Roth, you can buy and sell investments in the account with no tax penalty, and dividends or other income that you earn will also not trigger any taxes.

IRAs have an annual contribution limit. In 2021, that limit is $ 6,000 or $ 7,000 if you are 50 years of age or older. This is a limit over everything Your IRAs, traditional or Roth. In addition, you can only contribute to a Roth IRA if your income level is low enough. In 2021, the partial contribution limit is $ 140,000 for Modified Adjusted Gross Income (MAGI) for single applicants and $ 208,000 for joint applicants.

When you withdraw money from a Roth they get really amazing. For starters, you can withdraw your contributions at any time without penalty. So if you are in an emergency, you can get these contributions back (although you cannot decide later to put old contributions back into the account). However, here’s the really amazing part: if you are of retirement age (59 1/2 or older) you can withdraw your money Merits from a Roth IRA and it is not taxable income

A Roth IRA can be a good option if you are expecting more income in retirement or if you are anticipating an increase in taxes.

  • Advantages: Roth IRAs are easy to set up, you can rebalance with no tax worries, you can withdraw contributions with no penalty, no taxes on profits when withdrawn in retirement
  • Disadvantage: Limit of income, limitation of annual contributions, contributions not tax deductible

Which option should you choose?

If you have a company pension plan and your employer offers appropriate contributions, this is the best option every time. Contribute enough to this plan to get every penny of the matching. This matching money breaks the tax breaks of other accounts.

There’s also the Roth IRA; Contribute as much as you can, up to the annual limit. If you want to contribute more, use your company pension plan, if available.

Or consider a traditional IRA. In this situation, it is very similar to your options for retirement in the workplace, but you will likely have more and better investment options. To contribute more than the IRA annual limit, use your company retirement plan, if available.

Use a regular investment account only for retirement when you have no other options.

This content is provided for informational purposes only and is not intended as professional advice. We appreciate your feedback on this article. contact us under [email protected] with comments or questions.


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