If there’s one thing we always say about investing, it’s that the earlier, the better. Starting to save for your retirement as soon as possible means you have more time to contribute to your fund and grow your investments. It’s important to note, however, that not all retirement funds are created equally. Choosing the right type of account (or the right combination of accounts) for your situation is essential for your future.
There are four common types of retirement funds. Here’s what you should know about each of them.
4 Types of Retirement Funds
1. Traditional 401(k)s
Traditional 401(k)s and their variants are retirement plans sponsored by employers. Both you and your employer can contribute pre-tax funds. Employers are not required to match your contributions. But many offer matching in their employee benefits packages. You can then write the amount off on your tax returns. This will lower your annual gross income and, therefore, tax bracket. But when you want to withdraw the money, your total investment (including any interest earned) will be taxed at your current tax bracket.
There are, however, limits to how much you can contribute to a traditional 401(k) fund. In 2020, for example, the IRS set annual employee contribution limits. It’s $19,500 for workers under 50 years of age, and $26,000 for workers over 50 years old. For combined employee-employer contributions, or for employees who invest beyond the maximum tax deduction, the IRS set the limit at $57,000 or $63,500, respectively.
Withdrawal requirements for 401(k)s are rather strict. You will be charged a 10 percent early-withdrawal penalty. Plus applicable taxes for removing funds before the age of 59 and a half years old. (There are, however, some circumstances in which the fee will be waived.) That said, Traditional 401(k)s have required minimum distributions (RMDs). This means that (as of 2020) beginning at age 72, you’re required to take out a minimum payment from your 401(k). This is true whether or not you need or want the money. (If you still work for the company holding your 401(k), you may be exempt from RMDs.)
2. Roth 401(k)s
Roth 401(k)s are also company-sponsored retirement plans to which you can contribute funds. But, unlike Traditional 401(k)s, these funds are already taxed. When you want to withdraw your money, you can take it out tax-free. But you won’t be able to write off your yearly contributions on your tax returns in the meantime.
The IRS limits your contribution to a Roth 401(k), as well. These limits are the same as for a Traditional 401(k). If you have both a Traditional and a Roth 401(k) account, contributions to both accounts cannot exceed the aforementioned annual limit. Roth 401(k)s also have RMDs.
3. Traditional IRAs
IRAs are individual retirement accounts to help individuals, freelancers and sole employers save for retirement. Like Traditional 401(k)s, they have yearly tax benefits. Also similar to traditional 401(k)s, they levy a 10 percent penalty on top of taxes if you pull out your funds before 59 and a half years of age. (There are some special circumstances that waive the fee.)
With a traditional IRA, you can contribute up to $6,000 as long as you’re younger than 70 and a half years old, regardless of your tax bracket. It’s also important to note that, with a traditional IRA, RMDs are mandatory, taxable withdrawals that are automatically paid out once you hit 70 and a half years of age. The percentage that you are required to take is based on your age and the amount of money you have put away.
4. Roth IRAs
Roth IRAs are also individual retirement accounts to help individuals, freelancers and sole employers save for retirement. But, like Roth 401(k)s, the funds are taxed at contribution instead of at withdrawal.
In 2020, a single filer could contribute to a Roth IRA a maximum of $6,000 or $7,000 for those over 50 years old. With a Roth IRA, you can withdraw funds at any time both tax- and penalty free so long as you’ve had your account open for at least five years.
Unlike Traditional IRAs, Roth IRAs have no RMDs. This makes them great wealth-transfer vehicles.
There are also other types of IRA plans, such as Spousal IRAs for spouses, Rollover IRAs for anyone rolling over funds from previous ones, Simplified Employee Pension (SEP) IRAs for small-business owners, and Savings Incentive Match for Employees (SIMPLE) IRAs that are similar to 401(k)s for employees.
Many people choose to open more than one type of retirement account. That’s largely because all types of accounts have different contribution caps, tax rules, and regulations for when you’re allowed to (and have to) withdraw your funds. In other words: There are limitations and benefits to each. It’s up to you to decide which type of fund or which combination of funds makes the most sense for you.