Retirement carries a different meaning to every individual. For some, the ability to hit the golf course every weekday propels them forward. For others, retirement means spending quality time with family during their golden years. That being said, the way you see retirement does not matter nearly as much as how you save for your retirement. The investment instruments you use to fund your retirement matter a lot more than you think. Some retirement accounts serve to benefit certain age groups more than others, and knowing which instruments stand to help you in the long term and help your retirement “nest egg” grow faster is critical to a successful and thriving retirement. The primary instruments used today are a traditional IRA, Roth IRA, and employer 401K plan. Here we briefly review the attributes and benefits of each of these instruments to consider when choosing which investment instruments may work best for your situation.
A traditional IRA is an account where your contribution is tax-deductible during the year it is being deposited into the account. You set aside a certain percentage of your paycheck to be invested into certain mutual funds that you select prior to contributing. Many companies that set up your IRA give you suggestions on which types of mutual funds fit best with your age and risk tolerance. The closer you are to retirement, the lower your risk tolerance typically should be. The maximum contribution amount for 2019 into a traditional IRA is $6,000 per individual, with a $1,000 catch-up contribution allowed for individuals age 50 and older.
Who Should Consider a Traditional IRA?
People who don’t see their income levels increase drastically in the coming years and subsequently placing them in a higher tax bracket can benefit the most from this type of account. As compared to a Roth IRA, the tax benefit for a traditional IRA is on the front end with each contribution lowering your adjusted gross income at year-end and therefore lowering your tax liability. However, once you withdraw from the account, the withdrawals are taxed at the applicable tax rate. People closer to retirement seem to benefit more from this type of account, as their working incomes are most likely at the highest levels they’ll be at in their lives and there’s no point in paying the tax now at a higher rate when it’ll eventually be taxed at the same, if not, a lower rate once the individual reaches retirement.
A Roth IRA functions exactly like a traditional IRA, except the tax benefit is on the back end compared to the front end. Roth IRA contributions are deposited into the individual’s account, but the contributions are not deductible. Therefore, they’re taxed at the applicable tax rate of the individual contributing to the account at the time of deposit. As a result, they are not taxed once withdrawn during retirement. Just like the traditional IRA, the maximum contribution amount for 2019 into a Roth IRA is $6,000 per individual, with a $1,000 catch-up contribution allowed for individuals age 50 and older.
Who Should Consider a Roth IRA?
Members of the workforce who believe their annual income is going to increase in future years and push them into higher tax brackets serve to benefit the most from a Roth IRA. Paying the tax at their current tax rate means they will be able to withdraw from the account tax-free when retired. This lack of taxation includes gains made by the account. Although it may be a gamble on what future tax rates will look like, people who believe they’ll see substantial growth in their income levels should take advantage of this type of investment. A Roth IRA also holds the benefit of being able to withdraw $10,000 from the account for the purchase of a first home, if it has been at least five years since the first Roth IRA contribution was made. If it has been less than five years since the first Roth IRA contribution was made, income taxes will be paid on the $10,000 distribution, however, no early distribution penalty will be incurred. This exception benefits a younger demographic as well, as most first home buyers are further away from retirement compared to those who may already own a home.
An employer 401K plan is set up by an employer where employees contribute a fixed percentage of their paycheck that is tax-deductible in the year of contribution. The advantage of this type of account is the employer’s matching principal on the account, if applicable. This match is typically subject to a vesting period, meaning that the employee must stay at the employer for a certain number of years before the company match into the account is 100% theirs. If an employee leaves the employer before the match is vested, they lose part of the match provided by the employer.
Most employers will match an employee’s contributions to a certain percentage threshold. Every employer is different, so inquire of your respective HR department what your company’s 401K matching percentage is and what the vesting period is as well. The maximum contribution amount for 2019 into a company 401K is $19,000 per individual, with a $6,000 catch-up contribution allowed for individuals age 50 or older.
Who Should Consider an Employer 401K?
Any employee, regardless of age, serves to benefit from an employer 401K plan. Employees who do not contribute at the least to the company match threshold offered are leaving free money for their retirement on the table. The account functions much like a traditional IRA aside from the matching benefit, as withdrawals are taxed on the back end during retirement. The importance of taking advantage of the matching benefit cannot be understated. These extra contributions may seem small in the short term, but give them 20, 30, or 40 years to grow and they can make a big impact on your retirement account balance.
No one knows what the future holds regarding tax law, so periodically checking with your accountant on what instruments your money is in is key to tax savings and overall retirement fund growth. Consistent contributions over time, regardless of market fluctuations, serve to benefit you once you are ready to retire. Any retirement account is a smart decision, so get started with saving for your retirement sooner rather than later. This especially applies if you’re in the younger demographic who see to benefit from years of growth and compound interest on their retirement funds. Albert Einstein once called compound interest “the 8th wonder of the world,” and taking full advantage of compound interest will greatly benefit individuals who start investing at a young age. Make sure you’re set up for your golden years and do your homework on what type of accounts serve to benefit you the most in order to have a happy and prosperous retirement.
If you need assistance or have questions about your retirement accounts, Selden Fox can help. For additional information please call us at 630.954.1400 or click here to contact us.