We’ve all seen the dire predictions about the future of programs like Social Security and Medicare–there will be a lot more dollars going out than coming in, and more retirees than workers, according to some estimates. This means that those of us far from retirement age might need to start expecting a much lower level of government-sponsored security when we get to our golden years. Gulp!
Fortunately, Social Security and Medicare aren’t the only ways that government sponsors our security for retirement–and the benefits are actually right there on the table waiting for you. Some of the main forms of subsidy are what are called tax-advantaged retirement accounts. These are accounts where you can save your money, make investments, and, later, withdraw your money–at much lower tax rates than if you made the same investments on your own. Awesome!
The government offers a number of different benefits tailored in various ways for different people, and the plan that makes the most sense for you will depend on your particular situation. We’ll run through a few of them now and you can think about which matches your personal needs!
1. Individual Retirement Accounts, or IRAs
An IRA is basically what it sounds like: an account that you put your savings in for retirement. Unlike your savings account, however, this one comes with a lot of bells and whistles that make it worth checking out.
First of all, an IRA is exactly what the “A” says: an account. It’s not an investment on its own, but rather a place to stock your cash that gives you tax benefits for keeping it there. However, instead of just sitting there gathering more dust than interest, you can put your money to use.
The way it works is that any investment moves that you’d like to make–buying and selling stocks, bonds, mutual funds, ETFs, and more–can be done literally tax free. Did you use your IRA to buy Apple stock at $10, and now it’s over $400? You can sell it, make a killing, and not pay any taxes until you start taking it out for retirement. In the meantime, any rewards you earn are yours to reinvest.
On the other hand, it’s not tax-free forever, and you can’t invest an infinite amount–only $5,500 for younger workers, and $6,500 for those over fifty. But if you have the cash flow to enable it, you should throw in the full amount and make your investments in there instead. On the bright side, any contributions you make–say, that $5,500 max–are not taxed as earnings in the current year, only when they’re withdrawn! The last potential drawback is a penalty of 10% if you withdraw before retirement age (59 and ½), but all in all the benefits are exceptional.
2. Roth IRA
Roth IRAs are like regular IRAs twin, only instead of being evil they are awesome! With a regular IRA, you can contribute $5,500 when you’re 30 and pay no taxes until you withdraw at 60, letting you get the most bang for your buck in terms of making a larger initial investment. Not bad! For a Roth IRA, on the other hand, your tax rate when you withdraw in retirement is: a whopping 0%.
Of course, there’s a catch. For Roth IRAs, you have to pay taxes on the money when you’re young, and so you’re getting a slightly lower initial investment. But any returns you reap are yours to keep–so if you’re starting early or anticipate large gains, a Roth IRA is a good way to go.
There are extra benefits, too. For IRAs, you have to start withdrawing at age 70, but for Roth IRAs there are no cutoffs. Second, you can withdraw as much money as you put in without paying any penalties. This doesn’t apply to earnings, but your initial $5,500 investment can be taken out at any time for no penalty. Good deal! The Roth IRA isn’t for everyone though–literally. There are income and earnings eligibility requirements, so the already-wealthy aren’t able to contribute extra, and the same limits apply. All in all, the Roth IRA is perhaps even better than the regular IRA.
3. The 401(k)
Finally, the illustrious 401(k) plan! This retirement account is offered in conjunction with your job. This means, first of all, that your wages go straight to the 401(k) after you sign up–removing the temptation to spend a dime as you never actually see the cash! Like the regular IRA, these contributions are made on a pre-tax basis and so you also don’t owe a dime of taxes on the share of your wages that you contribute–you’ll only owe taxes when you withdraw, either in retirement or early with a 10% penalty.
One additional benefit of the 401(k) plan is that many employers take advantage of people’s interest in the tax-deferred program to make matches of your contributions. For instance, some employers count as a benefit a match of up to 3% of your wage bill, on an annual basis. If you make $40,000 a year, this means they’re offering $1,200 per year, tax free, to pay for your retirement. Not a bad gig!
However, be careful with the match money. Many employers require a certain length of employment before the match actually kicks in, so if you don’t meet it you don’t get any of the match. You do get whatever money you socked away, no matter what, and after you pass the deadline then you get to keep all of the money. This is true even if you change jobs! In that case, you can do a “rollover” of your 401(k) savings into an IRA or into a new 401(k) at your new job.
4. Solo 401(k)
This plan is great for people like freelance journalists or solo musicians, because as the name suggests it’s a plan for those of us who are going “solo”. A Solo 401(k) is a traditional plan that covers a business owner and his or her spouse, as long as you have no other employees. This means that you can make both business contributions and employee contributions. As an employee you can put 100% of the money that you make up to $17,500 for under-50 year-olds and $23,000 if you are older. If you have another job elsewhere–as many of us freelancers do– that does have a 401(k) plan for employees, you can still have both plans. However, your yearly contribution still cannot exceed the $17,500 or $23,000 limit.
5. SEP-IRA
If you’ve been freelancing or a solo business owner for awhile, you’ll know that there are some difficult steps and decisions involved in hiring more employees. One of those difficulties involves finding a retirement plan for yourself and your employees if you’re operating a business, or even if you’re still operating alone!
SEP-IRA allows employers to contribute up to 25% of employees’ pay to a traditional IRA, but only the employer can make these contributions for employees. You choose the amount to contribute each year and must give everyone the same percentage. This is a great plan for small businesses especially because it allows you to be flexible with the contribution percentage on a year-by-year basis.
With a SEP-IRA, you contribute to a traditional IRA for employees (including yourself), up to 25% of their pay. However, employees can’t make their own contributions. Employers can choose the amount to contribute each year, but must give all employees the same percentage. So if you’re business has a bad year and you can’t really afford to contribute as much as in the years past, you have that option.
6. SIMPLE IRA
SIMPLE IRA (Savings Incentive Match Plan for Employees) is plan that’s also better for smaller companies rather than huge ones, usually under 100 employees. It’s different from SEP-IRA because both employees and employers can make yearly contributions. This option is capped at $12,000 if you’re under 50 and $14,500 if you’re older for 2013.
Employers can either match what an employee contributes every year. But if an employee doesn’t keep up their account in the long run then the account stays intact, but the employee just won’t receive any contributions from the employer.
Alternatively, employers can opt to make a flat yearly contribution of 2% of pay, and the employee can put in however much more they’d like.
Which option is the best for you? Well, it depends on your situation: a 401(k) with employer match is great, but not all jobs come with one. The lower your income now the more sense a Roth IRA makes as you can pay low taxes at your current low income and avoid any taxes later on your investment earnings, which might come at a point when you have a higher income and thus a higher tax bracket. If you’re a freelancer or running a small business, you’ve got a whole boat of other options! These are just some of the most popular options, and in my opinion the best, but be sure to do careful research to choose which is right for you!
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