Using The Right Account Is Crucial
With almost a dozen different types of retirement accounts, Uncle Sam doesn’t make this simple. But we’ll try to. For most savers, and particularly young ones, a Roth IRA is a best bet. You get no tax deduction for your contributions to a Roth IRA, but the money in it grows tax free for retirement.
And this is key: Should you need cash earlier—say, to buy a house, pay for school, start a business or cover an emergency—you can take back your original contributions (though not earnings) without paying taxes or penalties. “A Roth IRA is the greatest all-purpose account. It’s the most flexible,” says retirement account expert Ed Slott of Rockville Centre, New York.
What if you are offered a 401(k) at work, or a similar 403(b) or 457 plan? If your employer offers a match—say, you put in 3% of salary and your employer puts in 3%—contribute as much as required to get the full match, then fund your Roth IRA, for maximum flexibility. Typically, your salary goes into a 401(k) before income tax is taken out and then all withdrawals in retirement get taxed. But some employer plans also offer the option of making after-tax Roth contributions, which grow tax free and can be spent tax free in retirement.
If you’re a high earner, pretax 401(k) contributions have appeal, particularly if they reduce your gross income low enough that you qualify for some tax benefit like the generous new child tax credit. But for young workers earning less, contributing to a Roth 401(k) can make sense—though it’s not quite as flexible as a Roth IRA.
What if you’ve started a side gig or your own business? Moonlighters who have 401(k)s at work can contribute up to 20% of net earnings to a simplified employee pension (SEP) IRA. Those who are entirely self-employed and want to save more may find a solo 401(k) works best.
Contribution Limits Vary
You can put up to $6,000 this year into a Roth or traditional IRA (or $7,000 if you’ll be 50 or older this year), so long as you have that much in earned income. There’s an income test that keeps high-income folks (more than $140,000 for a single individual or $208,000 for a couple) from contributing directly to a Roth IRA, but they can fund it anyway by contributing to a traditional nondeductible IRA and then immediately converting to a Roth. (Yep, that’s legal.)
You can stuff even more into a 401(k)—up to $19,500 a year ($26,000 if you’re 50 or older) in combined pretax and/or Roth employee contributions. And you can put up to $58,000 into that SEP IRA.
What about double-dipping? The good news is you can max out contributions to both a Roth IRA and a 401(k). But beware, anything you put in a SEP IRA reduces the $6,000 or $7,000 you can contribute to a Roth IRA, dollar for dollar.
Taking Money Out Early Is Tricky
You Can Have Too Many Accounts
Having multiple types of accounts allows you to save more and gives you more options for getting at your cash without penalty before retirement. But if you job hop, you can end up with too many small accounts scattered around, which can lead to unnecessary fees and make it harder to track your asset allocation.
This is crucial: If you switch jobs, don’t cash out your old 401(k)—the Employee Benefit Research Institute estimates that doing so increases your chance of running short of money in retirement by nearly a third. And, of course, you’ll owe tax and maybe a penalty.
Depending on the size of your 401(k) and your ex-employer’s policies, you may be able to leave the money where it is. But usually, a better long-term solution is to roll money from an old 401(k) into an IRA or into your 401(k) at a new employer. Always make sure to roll funds directly from one custodian to another in a trustee-to-trustee transfer. Don’t take out the money and move it yourself, or you could face a nasty and unexpected tax bill.
As a general rule, accounts can be combined only if they’re of the same type. So traditional IRAs should be combined with other traditional IRAs and Roth IRAs with Roths. But there are—once again—exceptions. For example, it’s possible to convert a traditional IRA into a Roth IRA, by paying the income tax due on the traditional IRA. After the conversion, the account grows tax free.
The Best Retirement Account Is Hidden
If you have access to a qualified high-deductible health insurance plan—and a third of workers do—you can put up to $3,600 for a single individual or $7,200 for a family into a health savings account (HSA) this year. You deduct the contribution from your current income, and it grows tax free and can be withdrawn tax free in retirement for health expenses. Here’s the appeal: No other retirement account offers tax savings on both the front and back end.
Now, it’s true that most folks with HSAs use the money each year for current medical expenses. But a better strategy—if you have the cash flow—is to pay current deductibles and copays out of your pocket and invest the money in your HSA, where it will grow tax free.
With so much of workers’ savings going into retirement accounts, it’s not surprising that many folks need access to these funds before retirement. Life happens. Remember, if you have a Roth IRA, you can withdraw the money you’ve contributed penalty free and tax free.
With other retirement accounts, you’ll generally be hit with a 10% penalty as well as ordinary income taxes if you take money out before you turn 59 1/2. But there are numerous and often confusing exceptions. For example, you can withdraw money for college tuition penalty free from an IRA but not from a 401(k). You can also take $10,000 penalty free for purchasing a first home from an IRA but not from a 401(k).
If you need cash and most of your wealth is tied up in a 401(k), consider a loan. You can borrow up to $50,000 or half the balance in your 401(k), whichever is less. You then gradually repay the money, plus interest, to your own account. If you leave the employer where your 401(k) is, you’ll have until October of the following year to put the borrowed money back into that 401(k) or a 401(k) at a new employer or an IRA. By paying the loan back, you avoid a current tax bill and preserve your retirement funds.
Another less desirable option is a 401(k) hardship withdrawal. Unfortunately, you can’t repay the money and must take a tax hit (including the 10% penalty if you’re under 59 1/2). What counts as a hardship? The definition is broad and generally includes medical expenses, home purchase costs, college costs, payments to prevent eviction or foreclosure, funeral expenses and home casualty loss repairs.