The Retirement Account Breakdown

So many retirement accounts, so little time. 

What do you dream of in retirement? Playing your favorite sport everyday? Living on the beach collecting sea shells? Gardening? Traveling the world? Staying with family? 

Wherever your day dreams take you, one thing's for certain: You'll likely need an account to park and grow your funds. There are many options to choose from and that's what we'll review in this blog.

A recent study showed close to 50% of Americans do not have any retirement savings, despite 57% naming retirement as their top financial priority. These Americans could have a 'defined benefit plan' (briefly explained towards the bottom) or they could be relying on social security or inheritance to see them through their non-working years.

What about social security benefits?

According to Investopedia.com, in a 2019 Gallup poll, 41% of individuals surveyed said they worry a great deal about Social Security. The same survey also revealed that 33% of individuals said they believe Social Security is going to be a major source of their income in retirement. Social Security has historically been structured to replace 40% of your income in retirement. The thought being that with all consumer debts being paid off, retirees can live on less than their current income. Depending on how you decide to spend your retirement, that could work for you. Most studies show that social security will still be around for the millennial generation but may be structured to replace a lower amount of income. 

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Want to know more about your social security benefits? Use the IRS calculator here to estimate your benefits.

What About Pensions?

A pension is an example of a defined benefit plan, which is a type of plan that's going the way of the dinosaurs. 

Defined Benefit Plans

Here's how they work:

The employer sets aside money for the employee's retirement. The amount is typically based on some kind of formula that considers factors like the employee's time with the company, salary, and age. 

This money is then invested, typically in a variety of mutual funds. The employer generally gets a tax break for contributions.

When the employee retires, they receive a yearly or monthly distribution, sometimes for life! 

The catch. The employer is responsible for paying out this distribution, no matter how the underlying investments perform. To keep up with these payments, many pension plans have gone broke. Forcing them to borrow money from current employee's plans to pay for retired employee's retirement distributions. 

As employees started to spend less time at companies & live much longer, defined benefit plans became even more expensive for employers. When these trends continued, 401ks and IRAs became more popular in the 1980's. This continues today and in 2018, the average amount of years employees worked for the same company decreased to 4.2.

The common retirement plans we see today are 'Defined Contribution Plans' and place more responsibility on the employee to participate by contributing and choosing how they would like their funds invested.

There's much debate about which is better and whose responsibility employee retirement should fall on. We'll leave this discussion for another time and focus on the main types of retirement plans that are found today, their features and the pros & cons of each account.

How to Prioritize What Retirement Accounts You Should Use

There are a few main features of each account that you'll want to weigh to determine what accounts (and in what order) will be best to contribute to.

• What you qualify for
• When you pay taxes
• How much you can contribute

Types of Retirement Accounts

The following are a list of the most common retirement accounts for both employed and self-employed individuals. There are a few more plans for government employees, but I'm leaving them out of this list to include more information on plans that apply to the majority of people.

• Traditional IRA
• Roth IRA
• Traditional (Qualified) 401k
• Roth 401k
• 403b
• SIMPLE (Savings Incentive Match Plans for Employees) IRA
• SEP (Simplified Employee Pension) IRA

Ok, let's jump in!

Traditional IRA

Who opens the account? You!

Maximum contribution per year (2020)? $6,000. $7,000 if you are over 50 years old.

When do I pay taxes? You'll pay taxes on the principle amount at income tax levels in the year that you withdraw. You'll pay long-term capital gains taxes on any appreciation or accumulated dividends at the time of withdraw.

When can I withdraw? Age 59.5. The IRS will force you to withdraw a 'required minimum distribution' (RMD) at age 72 (2020 rules)- so you can pay taxes on something! Early withdrawals will include a 10% penalty.

Pros:

1. Contributions are tax-deductible in the year that you contribute.
2. You have until April 15th of 2021 to contribute to your traditional IRA for 2020!
3. Have a traditional/qualified 401k? You can rollover those fund into a traditional IRA so you're not trying to keep track of multiple funds in multiple accounts.
4. This account is great if you feel like your taxes in retirement will be LESS than your taxes now (so basically your income will be lower at retirement than it is now). It could also be a good fit if you are really needing more tax deductions for this current year. 

Cons:

1. If you are contributing to an employer's retirement plan your contributions may NOT be tax deductible. For example, if you are single, your adjusted income is over $75,000, and you participate in your employer's retirement plan, the full amount of your Traditional IRA contributions would not be eligible for a tax deduction. So double check your tax bracket before contributing. Funds in this account will be the last set of funds you'll withdraw from in retirement. 

Roth IRA

Who opens the account? You!

Maximum contribution per year (2020)? $6,000. $7,000 if you are over 50 years old.

When do I pay taxes? You'll pay taxes on the principle amount at income tax levels in the year in which you contribute. You'll pay taxes on the appreciation and collected dividends at long-term capital gains rates when you withdraw.

When can I withdraw? Age 59.5, but you don't have to! Withdrawals must be taken after a five-year holding period. You can keep these funds for as long as you need and can pass them to a beneficiary if you wish. Early withdrawals will include a 10% penalty.

There are exceptions to the early withdrawal penalty, such as a first-time home purchase, college expenses, and birth or adoption expenses! So after 5 years, you can also use this as a type of emergency fund. 

Pros: 

1. Contributions grow tax deferred! In this account you pay taxes up front (so no deductions here). Then at retirement, you can take the principle out tax free!
2. You have until April 15th of 2021 to contribute to your Roth IRA for 2020!
3. These funds will be the first you use at retirement. This account might be right for you if you feel like you'll be making MORE money at time of retirement (or paying more taxes). That's why this account is often recommended to younger individuals who have a long time until they retire and will most likely be making more/paying more taxes at that time.

Cons: 

1. If your salary is very high, you may be considered a 'highly compensated employee.' If this is the case, you may be subject to more stringent contribution limits.

Traditional (Qualified) 401k

Who opens the account? Your employer holds the account, but you will be responsible for setting up your contributions and picking out your investment options. (ps- make sure your funds ARE invested! Many 401ks will automatically place your money in a savings like money market- making virtually nothing- until you pick out your investments).

Maximum contribution per year (2020)? $19,500. If you're over 50 years old, you can contribute an additional $6,500. 

When do I pay taxes? You'll pay taxes on the principle amount at income tax levels in the year that you withdraw. You'll pay long-term capital gains taxes on any appreciation or accumulated dividends at the time of withdraw.

When can I withdraw? Age 55 if you are retired and not working, otherwise 59.5 (although if you're still working you may still incur a penalty). RMD's will start at age 72. Early withdrawals are subject to a 10% penalty.

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Pros: 

1. High level of contributions to accelerate your retirement savings!
2. Contributions are tax-deductible in the year that you contribute.
3. Deductions are AUTOMATICALLY deducted from your paycheck! This is one of the biggest benefits because it makes saving in this account easy and pretty painless.
4. Your employer may give you FREE MONEY by matching your contributions (up to an additional $37,500 if you're a high income earner). Employer-matching funds are NOT included in the maximum contribution limits. If this is an available option to you, take it. It's worked into your compensation plan and there is very little reason to leave money on table.
5. Leaving your employer? You can rollover those fund into a traditional IRA so you're not trying to keep track of multiple funds in multiple accounts.
6. This account is great if you feel like your taxes in retirement will be LESS than your taxes now (so basically your income will be lower at retirement than it is now). It could also be a good fit if you are really needing more tax deductions for this current year. 

Cons:

1. If your salary is very high, you may be considered a 'highly compensated employee.' If this is the case, you may be subject to more stringent contribution limits.

Roth 401k

Who opens the account? Your employer holds the account, but you will be responsible for setting up your contributions and picking out your investment options. (ps- make sure your funds ARE invested! Many 401ks will automatically place your money in a savings like money market- making nothing- until you pick out your investments).

Maximum contribution per year (2020)? $19,500. If you're over 50 years old, you can contribute an additional $6,500. 

When do I pay taxes? You'll pay taxes on the principle amount at income tax levels in the year in which you contribute. You'll pay taxes on the appreciation and collected dividends at long-term capital gains rates when you withdraw.

When can I withdraw? Age 59.5, but you don't have to! Withdrawals must be taken after a five-year holding period. You can keep these funds for as long as you need and can pass them to a beneficiary if you wish. Early withdrawals will include a 10% penalty.

There are exceptions to the early withdrawal penalty, such as a first-time home purchase, college expenses, and birth or adoption expenses! So after 5 years, you can also use this as a type of emergency fund. I've used it like this-- very helpful!

Pros: 

1. High level of contributions to accelerate your retirement savings!
2. Contributions grow tax deferred! In this account you pay taxes up front (so no deductions here). Then at retirement, you can take the principle out tax free!
3. Deductions are AUTOMATICALLY deducted from your paycheck! This is one of the biggest benefits because it makes saving in this account easy.
4. Your employer may give you FREE MONEY by way of matching your contributions (up to an additional $37,500 if you're a high income earner). Employer-matching funds are NOT included in the maximum contribution limits. If this is an available option to you, take it. It's worked into your compensation plan and there is very little reason to leave money on table.
5. These funds will be the first you use at retirement. This account might be right for you if you feel like you'll be making MORE money at time of retirement (or paying more taxes). That's why this account is often recommended to younger individuals who have a long time until they retire and will most likely be making more/paying more taxes at that time. 

Cons: 

1. If your salary is very high, you may be considered a 'highly compensated employee.' If this is the case, you may be subject to more stringent contribution limits.

403b 

This account is also called a tax-sheltered annuity or TSA plan. This plan is ONLY offered by public schools and certain 501(c)(3) tax-exempt organizations. It's very similar to a Traditional 401k.

Who opens the account? Your employer holds the account, but you will be responsible for setting up your contributions and picking out your investment options. 

Maximum contribution per year (2020)? $19,500. If you're over 50 years old, you can contribute an additional $6,500. You may be eligible for extra contributions if you qualify for the '15- year rule,' which means that you've been working in for a qualified 501(c)(3) organization for 15 years.

When do I pay taxes? You'll pay taxes on the principle amount at income tax levels in the year that you withdraw. You'll pay long-term capital gains taxes on any appreciation or accumulated dividends at the time of withdraw.

When can I withdraw? Age 59.5. Early withdrawals will include a 10% penalty.

Pros: 

1. High level of contributions to accelerate your retirement savings!
2. Your employer may offer a Roth option (will act very similar to a Roth 401k).
3. High level of contributions to accelerate your retirement savings!
4. Contributions are tax-deductible in the year that you contribute.
5. Deductions are AUTOMATICALLY deducted from your paycheck! This is one of the biggest benefits because it makes saving in this account easy.
6. Your employer may give you FREE MONEY by way of matching your contributions. If this is an available option to you, take it. It's worked into your compensation plan and there is very little reason to leave money on table.
7. Leaving your employer? You can rollover those fund into a traditional IRA so you're not trying to keep track of multiple funds in multiple accounts.
8. This account is great if you feel like your taxes in retirement will be LESS than your taxes now (so basically your income will be lower at retirement than it is now). It could also be a good fit if you are really needing more tax deductions for this current year. 

Cons: 

1. If your salary is very high, you may be considered a 'highly compensated employee.' If this is the case, you may be subject to more stringent contribution limits.
2. Some plans have limited and more conservative investment options than a 401k or IRA.

SIMPLE (Savings Incentive Match Plans for Employees) IRA

A SIMPLE IRA plan (Savings Incentive Match PLan for Employees) allows employees and employers to contribute to traditional IRAs set up for employees. It is ideally suited as a start-up retirement savings plan for small businesses not currently sponsoring a retirement plan.

Who opens the account? The small business will open and fund the account. Employees can contribute if they would like to.

Maximum contribution per year (2020)? For 2020 and 2021, employees can defer up to $13,500 of income to a SIMPLE IRA. If you're over 50, you can add an additional $3,000.

Employer is required to contribute each year:

• A matching contribution up to 3% of compensation OR
• 2% nonelective contribution for each eligible employee.

When do I pay taxes? You'll pay taxes on the principle amount at income tax levels in the year that you withdraw. You'll pay long-term capital gains taxes on any appreciation or accumulated dividends at the time of withdraw.

When can I withdraw? Age 59.5. Early withdrawals will include a 10% penalty. If you withdraw within the first 2 years, the penalty increases to 25%.

Pros: 

1. Available to any small business – generally with 100 or fewer employees.
2. No filing requirement for the employer and easy to set up.
3. Tax credits for the small business for the costs of setting up the SIMPLE IRA.
4. High level of contributions to accelerate your retirement savings!
5. Contributions are tax-deductible in the year that you contribute.
6. Deductions are AUTOMATICALLY deducted from your paycheck! This is one of the biggest benefits because it makes saving in this account easy.
7. Your employer may give you FREE MONEY by way of matching your contributions. If this is an available option to you, take it. It's worked into your compensation plan and there is very little reason to leave money on table.
8. Leaving your employer? You can rollover those fund into a traditional IRA so you're not trying to keep track of multiple funds in multiple accounts.
9. Funds HAVE to be vested immediately, which means more growth for you!

Cons: 

1. If your salary is very high, you may be considered a 'highly compensated employee.' If this is the case, you may be subject to more stringent contribution limits.
2. Some plans have limited and more conservative investment options than a 401k or IRA.
3. No Roth options.

SEP (Simplified Employee Pension) IRA

A SEP plan allows employers to contribute to traditional IRAs set up for employees. A business of any size, even self-employed, can establish a SEP IRA.

Who opens the account? The business will open and fund the account. Employees CANNOT contribute.

Maximum contribution per year (2020)? 

Contributions an employer can make to an employee's SEP-IRA cannot exceed the lesser of:

1. 25% of the employee's compensation, OR
2. $57,000 for 2020

When do I pay taxes? You'll pay taxes on the principle amount at income tax levels in the year that you withdraw. You'll pay long-term capital gains taxes on any appreciation or accumulated dividends at the time of withdraw.

When can I withdraw? Age 59.5. Early withdrawals will include a 10% penalty.

Pros: 

1. Available to any business – including self-employed and sole proprietorships. 
2. No filing requirement for the employer and easy to set up.
3. Tax credits for the small business for the costs of setting up the SIMPLE IRA.
4. High level of contributions to accelerate your retirement savings!
5. Contributions are tax-deductible in the year that you contribute.
6. Your employer gives you FREE MONEY depending on the cash flow of the business.
7. Leaving your employer? You can rollover those fund into a traditional IRA so you're not trying to keep track of multiple funds in multiple accounts.
8. Funds HAVE to be vested immediately, which means more growth for you!
9. Tax credits for the business.

Cons: 

1. Some plans have limited and more conservative investment options than a 401k or IRA.
2. No Roth options.
3. Employees cannot contribute.
4. Employers may change contributions year to year depending on the business's cash flow needs. 

I'll also be posting condensed versions of this information on Instagram, check it out here!

As you can see picking your retirement account strategy requires a peak into the future and some planning. Retirement is truly a taxes game. My recommendation is to start at the end. You don't have to have every detail figured out, but having an idea of when you want to retire and what kind of lifestyle you want to live can be a big help. It can also motivate you to stay on track. 

Whatever direction you decide to go in, do it as early as possible. Any retirement account needs time to grow in the market. Take a look at one of my favorite investment calculators to calculate how fast your money can grow. I use a rate of 7% as a conservative estimate (the S&P500 has returned over 10% since inception). Play with the numbers to see how much you need to contribute to meet you goals!