Millennials will be one of the first generations of Americans required to fund nearly 100% of our own retirement. However, according to a new survey by Morning Consult, in partnership with the CFP Board, an alarming number (nearly one-third) of workers can’t answer whether or not their employer offers them a retirement plan benefit at work. This article made me think that maybe I should give at least a basic overview of the different types of investment accounts. Keep in mind these descriptions aren’t all-encompassing of every rule, advantage or disadvantage for each account type, but these should at least get you started in the right direction with your savings plan.
Non-Retirement Account (Non-IRA) – A non-IRA simply refers to any account without a tax-deferred or tax-free status. If you own investments in a non-IRA account (also referred to as a taxable account) and your investment grows in value over what you originally paid, and you then sell it, you will pay taxes (as necessary) on the capital gains in that year. Capital gains refers to the amount of growth over and above your initial investment. As well, if a dividend or interest payment is paid into this type of account, you pay taxes on that income in the year it is paid.
This type of account can be titled individually, jointly with another individual or multiple other people, or can even be titled in the name of a trust or a business. Some non-IRAs may allow for a beneficiary to be designated for estate planning purposes, but this feature is not always available.
IRA – IRA stands for Individual Retirement Arrangement. It is more commonly referred to a retirement account or a traditional IRA. This type of account has a tax-deferred status meaning contributions are made pre-tax and taxes are generally not assessed on the contributions or the investment earnings until the money is withdrawn.
Your income determines your eligibility to make a pre-tax contribution to an IRA and there is a limit on how much money can be contributed to an IRA each year. In 2019, the IRA contribution limit is $6,000 or the total amount of your earned income, whichever is less. (Meaning, if you earn $4,000 in 2019, then you can only contribute up to $4,000 to your IRA.) Individuals age 50+ can also make a catch-up contribution of $1,000 in 2019. If you withdraw from this type of account prior to age 59½ there is a 10% penalty in addition to applicable income taxes on your withdrawal. At age 70½, IRA owners can no longer make contributions and will be subject to mandatory annual withdrawals called Required Minimum Distributions (RMD), on which they must pay ordinary income taxes.
IRA accounts can have only one account owner and always offer the option to designate a beneficiary. In addition to a traditional IRA account, you may also see other types of IRAs including: rollover IRAs, SEP IRAs, SIMPLE IRAs or Roth IRAs. A rollover IRA functions the same as a traditional IRA and is used to rollover previous employer retirement plans. SEP IRAs and SIMPLE IRAs have a different set of rules and are used as small business retirement plans. We’ll discuss Roth IRAs next.
Roth IRA –Roth IRA contributions are made post-tax, then earnings grow tax-free for the life of the account. Similar to a traditional IRA account, Roth accounts can only have one account owner and will always have an option to designate a beneficiary.
Also, like an IRA account, there is a limit to how much you can contribute to a Roth IRA, and the limits are the same for both account types in 2019, $6,000. Catch-up contributions are allowed for individuals age 50+ as well. Unlike an IRA account, not everyone qualifies to make a Roth contribution. Your income determines your eligibility, and when you make over a certain amount (determined each year by the IRS), you may not qualify to contribute to this type of account at all. Also, unlike an IRA account, contributions can continue to be made to a Roth IRA after age 70½ as long as there is earned income and this type of account is never subject to mandatory withdrawals. One last difference is the Roth IRA 5-year rule which states that a person can only withdraw their earnings tax-free after 5 years has passed since the very first IRA contribution. Owners must also have attained age 59½ or some other qualifying event to qualify for tax-free distributions of earnings on these accounts. Contributions can be withdrawn tax and penalty-free at any time.
401k/403b – Many, but not all employers offer a 401k retirement account, which carries a tax-deferred status. For those working for non-profit businesses, your version of a 401k is likely a 403b plan. These two types of plans function similarly to each other. The money you contribute to a 401k or 403b (usually via salary reductions) is pre-tax and the taxes on the contributions and earnings are deferred until you withdraw the funds from the account. Some 401k and 403b plan sponsors also offer a Roth version of their accounts where contributions are made post-tax and earnings can be withdrawn tax-free after the 5 year rule is satisfied and the owner has attained age 59½.
There are three key differences between IRAs and 401k/403b plans. First, the maximum you can contribute to these plans is much higher and is only dependent on having enough earned income to fund the max. In 2019, the maximum amount you can contribute from your salary is $19,000. Unless you are age 50+, in which case you are eligible for a catch-up contribution of an additional $6,000. The second difference is the employer match. Most companies that offer a 401k or 403b plan have some sort of matching program where the employer contributes the same amount you do, up to a certain percentage. Company matches can vary widely, and not all 401k or 403b plans offer them. If your company does offer a match and you’re not contributing, you’re leaving free money on the table. The third difference is related to aging. At 70½, if you are still working, in most situations you can delay RMDs and continue contributing to either of these account types.
Make sure you review and understand the full details of any account before you open it or start funding it. There are many IRS rules that govern retirement accounts, in addition to specific 401k or 403b plan sponsor rules you should familiarize yourself with prior to making contributions or taking a withdrawal.
In general, when you are considering where to invest first, starting with an employer plan is usually best given the high contribution limits and the likelihood of a company match. Many employer plans also offer simple investment options that will adjust the risk you take automatically based on the year you plan to retire. If you don’t have an employer plan available or have maxed out your contributions, look to see whether you qualify to make deductible IRA contributions or a Roth IRA contribution for further tax-deferred or tax-free investment growth. Speak with a tax advisor if you’re not sure whether you qualify. If you’ve maxed out both your employer plan and your IRA or Roth IRA contributions in any given year, additional retirement or investment savings can go toward a taxable account. When in doubt about what to do with your plan, ask a professional (like one of us) for help.