Retirement Accounts: 401K, 403B, IRA, and what are they?

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There are three important phases of an individual’s life. These are the childhood, the youth, and the old age. The most crucial phase is the old age. It is the phase where all our near and dear ones leave us to die. At this stage only those succeed who had maintained a good financial house and planned for this stage. Employment is a precious gift. But it does not last forever because there comes an age when working is simply not possible or simply not desired. For me I hope my situation is the latter due to a well-planned choice. Many confront this situation with bewilderment, but if you have stuck to a good retirement plan, you need not worry.

The most beneficial way to save for retirement is to utilize all the tax advantaged accounts available for the purpose of retirement. These accounts grow tax free and can be funded with pre-tax or post-tax money. To understand this concept, we will first define the IRA.

What is an IRA

IRA (Individual Retirement Account) is a retirement plan that is offered by many financial institutions, or governments to give them tax benefits. There are several types of IRA’s. These are:

1-Traditional IRA

It is the first and foremost type of IRA where an individual submits his or her pre-tax and after-tax income and it allows growing your money tax deferred. Usually, the amount is not subjected to taxation until its distribution. For example, let’s say you earned $100,000 and maxed out your IRA contribution for the year, which is $5,500 for 2017 + a $1,000 catch up contribution for those over 50, you would then only be taxed as if you made $94,500 and the money would grow tax free. Hence, no capital gains taxes for being responsible and planning for the future. When you withdraw the money in retirement it is taxed as income, but the idea is at that time you will be in a lower tax bracket and pay less to Uncle Sam.

2-Roth IRA

The second most common type of Individual Retirement account is a Roth IRA. It is an account where you pay taxes for the money going into your account and the out flow will be totally tax free. For example, if you made a $100,000 and maxed out your contribution for a Roth account you would still be taxed as if you made $100,000. The money would still not be subjected to capital gains taxes as it grows, but when you take the money out it is not subjected to income tax since you already paid this tax before putting the money in.

Additionally, it is worth noting that there is an income retraction on those who can fund a Roth account. For those filing married they cannot contribute if their income exceeds $196,000. However, they mays still have Roth money in the retirement plan by funding through the “backdoor”. They can contribute to a traditional IRA and then convert the money to a Roth and pay the income taxes.  Why this extra step is in place and perfectly legal I don't know, but it is valuable information if you are a high-income earner. This is widely referred to as the backdoor Roth IRA.

3-Simple IRA

The third is a SIMPLE IRA. Simple stands for Savings Incentive Match Plan for Employees. If you have fewer than 100 employees this allows you to set up a plan with less paperwork. An employee can contribute a max of $12,500 in 2017, with a catch-up contribution of $3,000 allowed for those over 50. With a SIMPLE IRA, you may invest in the same plan after you acquire employees. However, don't forget that you must match your employees' contributions, up to 3% of their pay.

4-SEP IRA

Another kind of IRA is the SEP IRA. SEP stands for simplified employee pension. For a moonlighter or sole-proprietor it is typically the plan of choice. It functions like a traditional IRA, but has a contribution cap of $53,000. This is the case because you are making the contributions on behalf of the employer and the employee and in the case of a sole-proprietor you happen to be both. The only other stipulation to contributions is that they cannot exceed 25% of your net income.

Keep in mind these are accounts with special benefits for saving for retirement. So, if money is withdrawn before 59 and a half then capital gains taxes will need to be paid on the earnings at 18% and there will be an additional 10% penalty.

The 401(K)

Nowadays, the most widely used retirement account in America is the 401K. Almost, all the firms and organizations are offering this program. With the loss of the pension plan for many it has become even more necessary to become financially educated.

A 401k is an employer sponsored retirement plan that works very similar to an IRA. The contribution limit for an employee for 2017 is $18,000 and $24,000 for those 50 and older. The total that can be contributed to a plan from the employer and employee combined is $53,000 and $59,000 for those 50 and older.

For example, if you made a $100,000 and contributed the max of $18,000 then you would be taxed as if you only earned $82,000 for the year. That money would grow tax free in the account and when it is withdrawn in retirement taxes would be paid as if it were income.

Roth 401k

Some companies offer a Roth option and these function the same as a Roth IRA.

The distribution of it is also very complex as compared with other plans. It can be withdrawn under following conditions.

  • On the retirement, death, disability, or separation from the service which he or she had been doing.
  • On reaching the age of 59.5 years.
  • At the confrontation of hardships.
  • At the termination of the plan.

403 (b)

The third widely known retirement program is 403 b. This is the program for certain employees of public schools, tax exempted organizations or certain ministers. It is essentially a 401k for non-profits.

Solo-401k

This plan works exactly like a traditional 401k, but is intended for sole-proprietors who do not have any employees. These come in both traditional and Roth options. These plans are very ideal for those who are capable of savings large sums of money and are looking for a tax advantaged investment vehicle. Contributions are being made as both the employer and employer so the limits are $53,000 and $59,000 for those over 50 up to 25% of the net income. These plans require more paperwork than a SEP IRA, but provide some benefits not found in the SEP, like being able to borrow against the account.

 

Overall it is a no brainer to be investing for retirement and I would take full advantage of these accounts. The long-term compounding benefits of not paying more tax than you need is incredible and we all no Uncle Sam doesn’t need any more of your hard-earned money. Pay close attention to how you allocate your money between Roth and traditional accounts for purposes of overall return.  If you are in a low tax bracket I would go Roth all day, but if you make very good money then I would be trying to lower my tax burden as much as possible. Furthermore, when in retirement it is nice to have tax free money to manipulate your tax bracket and have more control over you finances. This post is getting long so expect a follow up on this topic.

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