Understanding the Use of Different Accounts for Your Retirement
How are you using the potential advantages of your accounts in your retirement planning?
There are a number of accounts with retirement planning benefits. Let’s look at four of the most common ones: 401(k) plans, individual retirement accounts (IRAs), health savings accounts (HSAs), and 529 plans.
1. 401(k) plans
One of the most popular types of retirement accounts, 401(k) plans are available through many employers. If your employer doesn’t offer a 401(k) plan—or if you’re self-employed — you can create your own, assuming you meet certain requirements (e.g., proving you’re responsible for your own income and you make a certain amount of money).
In 2019, those who participate in 401(k) plans are able to put up to $19,000 of pre-tax income in their accounts. Generally speaking, contribution limits increase over time (in 2018, the maximum contribution was $18,500). Those over the age of 50 can also make “catch-up contributions,” deferring an additional $6,000 to traditional 401(k) plans each year; Congress passed this provision in 2001 to help ensure baby boomers had enough money set aside for retirement. Individuals that qualify for catch-up contributions can put up to $25,000 into their 401(k) plans in 2019.
Many employers offer to match your 401(k) contributions up to a certain amount. For example, an employer might agree to match 50 percent of your contribution and/or up to 8 percent of your salary. Read the fine print of your company’s matching policy to understand the terms of your employer’s plan. Some employers might not release their contributions to you unless you’ve worked there for a specific amount of time.
Consider: Ask your financial advisor to review your retirement benefits and integrate them into your retirement plan. Afterall, that’s what we’re here for.
You may also be able to borrow from your 401(k) during a financial crisis—however this money must be repaid with interest or face penalties.
Unlike with a personal account or an IRA, you may have less flexibility in the securities in which you can invest. Finally, you can be hit with a 10 percent penalty if you withdraw funds before you turn 59½.
For many, however, the pros of 401(k) plans outweigh the cons.
2. Individual retirement accounts (IRAs)
IRAs are another kind of retirement account that offers potential tax benefits.
Unlike with 401(k) plans, employers don’t factor into the equation here. Anyone can open up an IRA, and qualified individuals can have an IRA and a 401(k) plan at the same time. Since they are retirement accounts that you control, IRAs let you buy and sell securities without paying capital gains taxes. However, taxes may have to be paid prior to contributing to an IRA or after withdrawal.
In 2019, individuals are allowed to deposit up to $6,000 in an IRA—and up to $7,000 if they are at least 50 years old by the end of this year. (Like with 401(k) plans, IRA limits increase over time. In 2018, the maximum contribution was $5,500—and $6,500 for those 50 and older.)
Here are the two most common types of IRAs:
- A traditional IRA is funded with tax-deferred dollars. You’ll need to pay taxes on your funds when you withdraw them during retirement. Since you don’t pay taxes up front, you have more funds to invest.
- A Roth IRA is funded with post-tax dollars. Since you’ve already paid taxes on these funds, you don’t have to pay taxes when you receive qualified distributions.
Some people drop to a lower tax bracket when their income decreases in retirement. This may provide an opportunity to convert a regular IRA into a Roth, called a Roth conversion. In a Roth conversion, you can pay your capital gains taxes up front to switch your IRA to a Roth, where you won’t pay taxes on distributions in the future. We highly recommend consulting with a tax professional or financial advisor and doing tax projections prior to trying this retirement strategy.
Like with 401(k) plans, you may be hit with a 10 percent penalty if you take money out of your IRA before you turn 59½. There are also penalties for withdrawing too late.
By April 1 after you turn 70½, you must take the required minimum distribution (known as an RMD) from certain accounts such as your traditional IRA and 401(k).
3. Health savings accounts (HSAs)
In an era of ever-increasing healthcare costs, many people include HSAs in their retirement plans.
You may qualify for an HSA if you have a high-deductible health insurance plan. These accounts can be funded with either pre-tax contributions or with post-tax income, which then becomes tax-deductible. Withdrawals for qualified medical expenses are tax-free.
Simply put, HSAs may allow you the opportunity to lower your taxable income while helping you accrue cash you can use to cover your medical expenses without paying taxes on those funds. In 2019, the limits for HSA contributions are $3,500 for an individual and $7,000 for a family (those 55 and older can contribute an additional $1,000).
4. 529 plans
According to the College Board, a moderate budget for in-state public colleges averaged $25,890 for the 2018-2019 school year. Private college costs doubled that figure, with the average budget coming in at $52,500. Multiply either figure by four and factor several kids into the mix, and all of a sudden college costs may have a significant impact on your retirement plan.
Enter the 529 plan, which is another type of tax-advantaged account that may play a role in your retirement plan. These plans, which are sponsored by states under Section 529 of the tax code, encourage workers to save for future education costs.
Broadly speaking, there are two kinds of 529 plans:
- Prepaid tuition plans enable participants to pay current tuition fees ahead of time for a beneficiary, usually at public or in-state colleges and universities. These funds cannot be used to cover room and board costs. According to the Securities and Exchange Commission (SEC), these funds may or may not be guaranteed, so it’s possible that you can lose this money during difficult financial periods. Make sure you understand the potential risks of a prepaid tuition plan before participating.
- Education savings plans enable participants to enjoy tax relief while saving for a future beneficiary’s tuition, fees, and room and board costs. Typically, these accounts may invest in mutual funds, bonds, and ETFs. According to the SEC, these accounts can be used to pay $10,000 per year per beneficiary at any public or private elementary or secondary school. Keep in mind that this regulation applies federally, but not all states complied with the regulation. This means that if you use it for elementary or secondary education in California, you could face a penalty. It is also worth noting that if these funds are not used for qualified educational events, you may incur penalties and any potential tax deferment would be waived. Always consult a tax professional prior to opening an Educational Savings Plan.
This is why many folks partner with financial advisors who should know the ins and outs of investment vehicles—and can offer advice that can help you retire when you want to and live the retirement lifestyle you dream of.
- What does your current retirement portfolio look like?
- What contributions are you making to your retirement accounts?
- What is your tax plan for your accounts?
- What are your projected investments at your retirement date?