The Basics of Retirement Accounts
While everyone knows the importance of saving for retirement, the vast menu of retirement savings plans can be quite confusing. Add in the questions of how they work and how much you should be contributing and it can make your head spin.
If that sounds familiar, you’re not alone. Federal Reserve System data shows that a quarter of U.S. residents – some 26% of Americans – have no retirement savings, and 44% don’t feel their retirement savings are on track. Confusion about how the system works is most definitely to blame for at least some of that.
Nonetheless, don’t panic. We’ve got a rundown on all the most common retirement accounts — including 401(k)s, 403(b)s, solo 401(k)s, IRAs and Roth IRAs — and how to use them. It should be just what you need to get you moving in the right direction.
Employer-Sponsored Retirement Plans
A 401(k), like similar accounts including 403(b)s, is a qualified employer-sponsored retirement plan. If your employer does not offer a 401(k) or other sponsored plan, you should probably begin saving in a Roth IRA or traditional IRA. But if you have access to an employer plan — especially if your employer offers matching contributions — that’s the best place to start.
Many employers offer a matching contribution up to a certain percentage of your salary. For instance, if your employer will match your 401(k) contributions up to 6% of your salary, you should aim to always contribute at least 6%. If not, you’re leaving free money on the table.
The money you contribute to a traditional 401(k) account is pre-tax money, meaning you will not be taxed on that money during the year you earned it (this will show up as a tax deduction, reducing your adjusted gross income for that year). Instead, the money will go into an investment account where it will typically grow over time, and you’ll pay taxes when you withdraw it during retirement. You may also have the option of choosing a Roth 401(k). Here, you’ll contribute post-tax dollars (i.e. money you’ve already paid taxes on), the money will grow tax free and you won’t owe any taxes upon withdrawal. For 2023, the IRS increased the annual 401(k) contribution limit from $20,500 to $22,500. Those 50 or older at the end of 2023 can make a catch-up contribution of $7,500.
An important thing to remember when considering your 401(k) is that it’s the account you put money into, not your actual investments. Once the money is in the account, you are responsible for choosing your investments and actually investing that money. Your investment options can include mutual funds, target-date retirement funds, stocks and other choices depending on your plan.
What’s a 403(b)?
A 403(b) plan is similar to a 401(k) plan, but it’s offered to employees of nonprofits as well as to some government employees. As with 401(k) plans, contributions to 403(b) plans are tax deductible, and employers can also offer matching contributions. In addition to investing in many of the same options offered in 401(k)s, 403(b)s have also offered the option to invest in annuities (which provide an income stream in retirement). Only recently has a change in the law started to bring annuities to 401(k)s.
There are many similarities between these two account types. They have the same contribution limits ($22,500 for 2023, with a $7,500 catch-up contribution for those 50 and over). Both types of plans require you to reach age 59 ½ before you can withdraw from them and impose a 10% penalty for early withdrawal. And both can offer Roth options if your employer adds that feature to your plan.
DIY Retirement Plans
If you don’t have an employer-sponsored retirement plan (and sometimes even if you do, but have the ability to save more), it’s time to look at IRAs. IRA stands for Individual Retirement Account and there are four different types — all of which fall under the heading of “self-directed” retirement plans, which is a fancy term for Doing It Yourself. All are accounts you open with a brokerage firm or other investment house, then contribute to and manage over time.
The original is a traditional IRA. You deposit pre-tax money, this reduces your adjusted gross income — up to $6,500 for 2023, plus another $1,000 in catch-up contributions for anyone 50 and over. Once invested, the money typically grows over time. And when you withdraw it, which you’re allowed to do without penalty beginning at age 59 ½ and must do starting at age 73 in 2023, you’ll pay ordinary income taxes on the withdrawals. If you have a retirement plan at work, you’re only eligible for a traditional deductible IRA if your income is below $73,000 (singles) or $116,000 (married, filing jointly) generally not eligible for a traditional deductible IRA. But you can always open and contribute to a non-deductible IRA. The money will still grow tax-deferred over time. And you’ll still pay income taxes upon withdrawal.
A Roth IRA is basically the opposite — taxwise — of a traditional IRA: You pay tax on income before you make contributions to the Roth IRA, but you’ll pay no tax on withdrawals of either your earnings or your contributions in retirement. There is a catch. Not everyone (even those who don’t have a work-based retirement plan) qualifies for a Roth IRA. Singles need a modified adjusted gross income of under $138,000 to contribute the full amount and $153,000 to contribute anything for 2023. If you’re married filing jointly income limits begin at $218,000 and phase out completely at $228,000.
A Word About Spousal IRAs
If you’re married and have a spouse in the workforce, you can contribute to retirement — for you — even if you’re not earning an income yourself by using a spousal IRA. With this account, the working spouse contributes on behalf of the spouse who isn’t earning income. “It’s the easiest thing to do if you have a spouse and file joint tax returns,” said Nasrin Mazooji of Ubiquity Retirement + Savings. “You can contribute to an IRA as long as your spouse has income.” Contribution limits are the same as for traditional IRAs and Roths.
And, If You’re Self Employed?
A solo 401(k) enables you to get many of the benefits of an employer-sponsored plan without having to work for someone else. Even better, the contribution limits are pretty generous because you can contribute for yourself as both an employer and an employee and also make catch-up contributions. For 2023, the total contribution for this particular account – not counting catch-up contributions for those age 50 and over – is $66,000. Want to know more? The IRS details the rules here. And just like 401(k)s at many employers, there’s also a Roth option.
Note: You do need an employer identification number for your own business to open a solo 401(k), which you can apply for on the IRS website.