It’s never too early to start saving for retirement.
Even if you don’t have a lot of money, you can still start a retirement savings habit. And if you use a tax-advantaged retirement account, your money will grow more efficiently because of your tax situation.
The earlier you start, the longer compound interest will work for you. That’s a good thing — you can do more with less when you get started immediately.
Here’s what you need to know about your tax-advantaged retirement savings options.
What are tax-advantaged retirement accounts?
When we talk about tax-advantaged retirement accounts, we’re talking about special accounts that the government recognizes as essential to helping Americans build a nest egg for the future.
In order to encourage us to save, the government gives us tax breaks. There are two types of tax-advantaged retirement savings options:
- Tax-deferred: Your money is put in your account before you pay taxes on it, meaning you get a tax deduction for your contribution. However, your taxes are only deferred until a later time. When you withdraw money from your retirement account, you have to pay taxes on that amount.
- Tax-free growth: Your contributions are made with after-tax dollars. However, even though you don’t get a tax deduction now, your money grows tax-free. This means that you don’t have to pay taxes on your money when you withdraw it during retirement.
Whether you choose a tax-deferred account or a tax-free growth account depends on what you think will happen with your taxes in the future.
Tax-deferred accounts have the advantage of offering you a little more cash flow each month. Since you’re contributing before taxes, that lowers what is taken from your check.
Plus, if you think you can regulate your income to stay in a lower tax bracket when you start withdrawing from your account, you can limit the tax damage.
If you think your taxes will be higher when you retire (either because of your income or because of inevitable tax hikes), a tax-free growth account can make sense.
You pay taxes today at a lower rate, and later you don’t have to worry about higher taxes. For those just starting out, this can be a great way to start saving for retirement. You’re in a lower tax bracket anyway.
The 401k is the most famous of the retirement savings options, and many employers offer 401k plans to their workers.
With this account, there are no income restrictions. For 2016 and 2017, you can contribute up to $18,000. (For those 50 and over, it’s possible to make a “catch-up” contribution of an additional $6,000 per year.)
One of the nice things about an employer-sponsored plan is the fact that you might receive a matching contribution. Your employer might put money into your account, matching your own contributions up to a certain amount.
This is essentially free money for your retirement. Pay attention, though: In some cases, you need to work for a set amount of years before the match portion is fully vested on your behalf.
You normally need to work for a private employer to get a 401k. For those who work at nonprofits or for the government, the retirement plans have similar benefits and rules as the 401k, but they have different names:
- Government Thrift Savings Plan
A traditional IRA is another tax-deferred account. Some employers offer this type of plan, but for the most part you open this account on your own. Many banks offer IRA accounts, and you can open an IRA at almost any online broker.
The limits for annual contributions to an IRA are much lower than what you see with a 401k. For 2016 and 2017, you can contribute up to $5,500 a year (with a “catch-up” of $1,000 a year if you’re 50 or older).
With a traditional IRA, you also need to be aware that your deduction eligibility phases out, depending on whether or not you (or your spouse) has an employer-sponsored plan and how much money you make.
You can still make your contributions, but they might not be fully tax-deductible.
Roth versions of retirement savings options
If you want tax-free growth and don’t mind paying taxes today in the hopes of saving big down the road, you can looking into Roth versions of both the IRA and the 401k.
Your contribution limits are the same with a Roth IRA as with the traditional version. However, there are income limits that dictate what you can contribute to a Roth IRA.
Each year, the IRS reviews inflation data and adjusts your ability to contribute. For the 2016 tax year, if you make over $117,000 a year as a single filer, your maximum contribution is reduced (and may even be set at zero). In 2017, that limit increases to $118,000 for singles. Joint filers have higher income limits.
Open a Roth 401k, however, and there are no income requirements for eligible contributions. The Roth 401k is a relatively new account, so it may not be available through your employer. If your employer doesn’t offer it, consider talking to your HR representative about the possibility.
Withdrawing from your retirement accounts
Because these are tax-advantaged accounts, the government wants you to wait until you are retired before you access the money you’ve deposited.
If you withdraw money from your traditional IRA or 401k before you’re 59½, you will pay a 10 percent penalty on top of the income taxes you owe for these tax-deferred accounts. It’s important to understand this consequence because it can cost you.
With Roth accounts, you can withdraw your contributions when you want without penalty. It’s post-tax money, so you don’t end up with the same fees. However, if you end up tapping into your earnings, you will pay the 10 percent penalty on those if you withdraw before age 59½.
Another quirk of tax-advantaged retirement savings options is the required minimum distributions (RMDs) that kick in later on. Many retirees try to limit their tax bill, particularly on tax-deferred accounts, by being careful about how much they withdraw. When you reach age 70½, the government requires you to withdraw a specific amount from your account.
Your RMDs for Roth 401k, traditional 401k, and traditional IRA accounts are based on a formula that includes how large your accounts are, your assets in other accounts, your age, and other items. It’s important to consider this over time so that you don’t get stuck with a huge tax bill later on.
Roth IRAs are an exception; there are no RMDs for the original owner of a Roth IRA account.
Lastly, it’s true that you can take out loans from your own tax-advantaged accounts and repay them over time, but beware of this strategy. It’s nice that you essentially pay interest to yourself, but you do miss out on the time that money could be earning interest.
Another worry is that if you lose your job before you pay off your 401k loan, the whole amount comes due within 60 days — or you pay taxes on the unpaid portion and the 10 percent penalty if you are under age 59½.
Converting your traditional accounts to Roth accounts
It is possible to convert some of your traditional accounts to Roth accounts. However, there are limitations. Make sure to consult with a professional before making this move.
Your biggest issue will be the tax bill. If you convert a tax-deferred account to a tax-free growth account, you need to pay taxes on that money. You might not want to convert all the money at once if you can’t handle the tax bill. Talk to a knowledgeable accountant about your options.
Self-employed retirement savings options
If you’re self-employed, you can open an IRA. Anyone with earned income can open an IRA and make contributions, but there are more options than just traditional and Roth IRAs.
Accounts aimed at the self-employed and business owners include SEP and SIMPLE IRAs. The contribution limits and eligibility requirements are a little different for these types of IRAs. However, they are still tax-advantaged accounts and they can help you kickstart your retirement savings.
If you want access to the benefits of a 401k but you don’t work for someone else, you might be able to open a Solo 401k. These are still relatively uncommon, and you’re more likely to find a bank or broker willing to open an IRA than a Solo 401k.
myRA: tax-advantaged accounts for low-income workers
A few years ago, the government announced the myRA. If your employer doesn’t offer a retirement plan, you can use the myRA and put away as little as $5 per paycheck. Contribution limits and withdrawal requirements are in line with a traditional IRA.
All of what you contribute goes into the Thrift Savings Plan Government Securities Investment Fund. Your principal is guaranteed by the government, so you don’t have to worry about losing what you originally put in. However, returns are usually lower than what you have the potential to see elsewhere.
For someone unsure of where to start, the myRA can make a good beginning. It’s possible to roll the money into a private account later.
Bonus round: HSA
Most wouldn’t think to include a Health Savings Account on a list of retirement savings options, but it can be a great addition to your retirement portfolio.
With the HSA, you receive a tax deduction for your contribution and the money grows tax-free as long as you withdraw it for qualified healthcare expenses. You can use this account as a retirement healthcare account and enjoy truly tax-free money, though you do need to meet eligibility requirements and contribution limits.
It’s possible to use the money anytime, as long as it’s for qualified healthcare expenses. When you use the money for non-qualified expenses, you pay a penalty.
However, you can treat the HSA as another IRA once you reach age 65 — you’ll have to pay taxes on money not used for healthcare costs, but the penalty disappears.
Now is the time to start saving for retirement. However you decide to do it, get going today. Tax-advantage accounts offer you the chance to boost your real returns and grow your wealth more efficiently over time.
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