TaxProfessionals.com
Posted by KLSM CPA Firm PLLC

Types of Retirement Accounts Explained & Broken Down

Types of Retirement Accounts Explained & Broken Down

Understanding how to plan for retirement doesn't have to be difficult. The various available retirement plans are easier to comprehend than you might think, although each has its limitations. Some of these limitations depend on adjusted gross income, while others limit the amount of money you can contribute annually.

The tax treatment of withdrawals and the age at which it is possible and necessary to make withdrawals without penalty may also vary depending on the type of plan. A comparison can help you identify which one is best for you.


401(k) Plans

This plan is a workplace retirement account offered to employees as a savings plan benefit. This account lets you contribute a portion of your pre-tax pay to tax-deferred investments. This reduces the amount of income to be taxed that year. For example, if you earned $75,000 and contributed $5,000 to 401(k), you would only pay taxes from the remaining $70,000.

Investment gains increase with tax deferral until you withdraw the money. However, if you withdraw funds from the plan before age 59½, you may pay a 10% penalty, and the withdrawal will be subject to federal and state taxes. However, some plans allow 401 loans (k) in case of emergency.

Some employers match their employee contributions with a 401(k), usually up to 6%. But, you may not be fully "vested" in your plan for several years. This means that you will not be able to take your employer's contributions with you if you leave the company before the prescribed period expires. However, your contributions to the plan still belong to you.

You risk losing an important social benefit if you don't match your company's contribution. That match is free money. Employers who offer these retirement plans are often willing to allow you to make contributions through automated payroll deductions, which makes saving easier.

Investment options for these types of plans are often limited, and administration and management fees can be high. The IRS imposes annual contribution limits, although the limits for 401(k) plans are more generous than other plans: $20,500 in 2022 (compared to $19,500 in 2021). It increases to $26,000 if you are 50 or older and take advantage of the allowed recovery contribution of $6,500.

Variations of this type of account include 403(b), a similar retirement plan offered to clergy, educators (e.g., in public schools), and workers at 501(c)-3 tax-exempt institutions; and 457(b) plans offered to local and state authorities.


Individual Retirement Accounts (IRA)

An IRA is a tax-subsidized investment account. You may use your account to invest in stocks, bonds, mutual funds, ETFs, and other types of investments after investing money and making investment decisions on your own, except if you want someone else to do it for you. You might contemplate investing in a traditional IRA if your employer does not provide a retirement plan or if you've exhausted your 401(k) contributions for the fiscal year.

You can contribute up to $6,000 in 2022. This limit increases to $7,000 if you are 50 or older. You will not pay an annual tax on investment gain, which allows them to grow more quickly.

Many taxpayers can deduct their IRA contributions from their tax returns if they don't have a 401(k) retirement account. This reduces their taxable income for that year. Some restrictions are based on income. You pay tax on the money you contribute and on the earnings when the money is withdrawn in retirement.

You can buy and sell investments under IRA, but if you try to withdraw money before age 59½, it's called an "early distribution," and you'll likely have to pay a 10% penalty just as you normally would with a 401(k). You will also be subject to federal and state taxes and income on the withdrawal.


Roth IRA

Unlike a traditional IRA, contributions to a Roth IRA are made in after-tax dollars, but the money generated in the Roth account is never returned.

You can withdraw contributions made to a Roth IRA before retirement age, without penalties, as long as 5-years have passed since the first contribution. Currently, you don't need to start retiring at age 72, as with traditional IRAs, 401(k), and other retirement savings plans.

Putting money into a Roth is a great place to invest extra cash if you're just starting out and think your income will grow. You can also contribute to an IRA and a Roth IRA, but your total contributions for both plans cannot exceed the contribution limit of $6,000 for the year or $7,000 if you're age 50 or older.


Roth 401(k)

A Roth 401(k) combines the features of a Roth IRA and a 401(k). It is a type of account provided by employers and was introduced in 2006. As with the Roth IRA, contributions come from an after-tax paycheck rather than a before-tax paycheck. A Roth's contributions and earnings are never taxed again if you've been in the plan for at least five years.

The beauty of a Roth 401(k) is that there is no income limit like a Roth IRA. Annual contributions are normally the same as a traditional 401(k) plan, with only after-tax dollars. Withdrawals are the same as for a Roth IRA, but distribution rules are the same as for a traditional 401(k).

SIMPLE-IRA

SIMPLE (Savings Incentive Match for Employees) IRA is a retirement plan that small businesses can offer with up to 100 employees. It works like a 401(k).

Contributions are made with pre-tax withdrawals, and the money grows tax-deferred until retirement.

However, early distributions can result in a significant penalty. Unless you are eligible for an exception, you will have to pay an additional 10% tax on the amount you withdraw from the SINGLE IRA (similar to traditional IRAs and 401(k) plans). If you withdraw within two years of first enrolling in the SIMPLE IRA, this additional fee increases to 25%.


SEP-IRA

The Simplified Employee Pension (SEP) IRA allows you to contribute part of your income to your retirement account if you are self-employed and have no employees. You can deduct these contributions from your taxable income.

The maximum limit for annual contributions is higher than most other tax-facilitated retirement accounts: $61,000 for 2022 (compared to $58,000 in 2021) or 25% of income, whichever is lower.


How much should you save for your retirement?

The amount of money you should save on your retirement depends on many factors, including your current living cost and salary. If you're searching for a good retirement savings goal, aim for 15% of your annual income, including employer contributions.


Can I have multiple IRAs?

You can have more than one IRA, but that doesn't change the amount you can contribute each year, which is $6,000 if you're under 50 and $7,000 if you're 50 or older.


Do I have to start withdrawing money from an IRA at some point?

There is no required minimum distribution for a Roth IRA, but for a traditional IRA, you must start withdrawing money from your account on April 1 after the year you turn 72 and on December 31 each year. This age is reduced to 70½ if you reach it before January 1, 2020.


FOR MORE INFORMATION ON HOW KLSM CPA FIRM, PLLC. CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLlICK THE BLUE TAB ON THIS PAGE.


THANKS FOR VISITING.

KLSM CPA Firm PLLC
Contact Member