Managing your 401(k), setting up an IRA, and managing your brokerage accounts have probably been on your to-do list for a while. You know that setting up your retirement – and getting a handle on these accounts is an important step in your long-term financial security, but you just don’t know where to start.
Let’s face it: Retirement can be complicated. You’re not stupid—or alone—if you get tripped up by all the retirement acronyms and terms. Don’t stress; we go into the major types of retirement accounts, from traditional IRAs to Roth IRAs to SEP IRAs to Simple IRAs to 401(k)s annuities. We even delve into brokerage accounts.
One of the most popular retirement savings vehicles is a 401(k). It’s an easy way to save for retirement, and it often offered through your employer along with health insurance, salary, and other perks. If you work at a nonprofit, you will likely be offered a 403(b).
Other options include brokerage accounts, ideal for those looking for a way to invest money for retirement, college, or another shorter term goal who are already contributing to a 401(k) and have an adequate emergency fund. These types of funds offer an option besides a 401(k) to invest in the market.
Everything You Need to Know About Your 401(k), IRA and Brokerage Accounts
Retirement can be complicated. You’re not stupid—or alone—if you get tripped up by all the retirement gobbledygook.
But don’t worry. We break down the six major types of retirement accounts, from traditional IRAs to Roth IRAs to SEP IRAs to Simple IRAs to 401(k)s annuities. We even delve into brokerage accounts.
So read on, and prepare to get inspired to retire… or at least save for retirement!
A traditional IRA is an acronym for “Individual Retirement Account” and is a type of retirement savings account. If you or your spouse earn taxable income and are younger than 70 ½, you can open an IRA and start contributing to it right away.
The best part? Your money won’t be taxed until you withdraw it, as long as it’s not earlier than age 59 ½. If you take money out prior to this, you’re charged a 10 percent penalty and have to pay taxes on top of it.
Your contributions to your IRA are either deductible or nondeductible. Whether your contributions are deductible or nondeductible will depend on your income. If your contributions are deductible, this will result in lower tax bills—yay!
Worth noting: if you’re contributing to an employer-sponsored retirement account like a 401k, you have to open a nondeductible IRA. While the contribution limits are the same, you don’t deduct them.
A traditional IRA is a good plan if you’re relatively certain you’ll retire before age 70 ½ which is the age you are required to begin taking distributions from traditional IRAs and pay income taxes on the money distributed. It’s also a good choice if you think you will be in a lower tax bracket than you are now once you’re over age 70 ½. You’ll not only be able to take those tax deductions now, if you may be able to be in that lesser bracket in retirement—hence, lower taxes. And who doesn’t want that?
You fund your Roth IRA with money you’ve already paid taxes on. As a result, your money grows tax-free. Plus, when you withdraw at retirement, assuming you are 59 ½ or older and have had the account open for at least 5 fives, you pay no taxes on it, period.
Contributions to Roth IRAs are limited by income level: $196,000 for married couples filing jointly and $133,000 if you’re filing as single or head of household. Your annual contribution limits are $5,500, or $6,500 if you are over age 50. You can contribute to both a traditional and Roth IRA, but the total can’t be more than $5,500 (or $6,500 if you’re age 50 and older), so keep that in mind.
A Roth IRA is ideal if you think you will be in the same or higher income bracket come retirement. Remember, tax-free withdrawals mean a lot in retirement, especially when you pay taxes on most other retirement accounts’ withdrawals.
If you’re still asking yourself, ‘What is an IRA?’ consider this: Another good aspect of a Roth IRA is that you are not required to start making withdrawals at age 70 ½, so your money can continue to grow tax-free until you need it.
Since your contributions to your Roth IRA are after-tax, the government gives you a break if you need to make an early withdrawal—i.e. before age 59 ½.
If you think you might need to tap into your account, like to pay for education (kids, grandkids, you or your spouse’s), medical bills that total more than 7.5 percent of your yearly income, or a down payment on a home (as long as it’s less than $10,000), you can withdraw the money you’ve contributed, just not the earnings, without penalty (as long as you’ve had the account for at least five years.
Another retirement savings option is the Simplified Employee Pension. Also known as a SEP IRA, this is a traditional IRA for those who are self-employed or run a small business.
If you fit this descriptor, you can open your own SEP IRA — with a few qualifications. For example, your employees cannot contribute to a SEP IRA, so as the small business owner, you must contribute to all employees who have worked for you for three of the past five years.
What you contribute is tax-deductible for the business (or for you if you’re a freelancer), and it goes into an account that’s similar to a traditional IRA, meaning the money isn’t taxed until withdrawal.
You can open a SEP at almost any bank or financial institution and can contribute as much as 25 percent of your self-employed income. Here are some restrictions if you’re an employer contributing to your employees’ accounts.
A SEP IRA is a good plan if you are self-employed, or a small business owner who wants to have an easy-to-manage retirement account.
Next up, the Simple IRA. Also known as the Savings Incentive Match Plan for Employees, this retirement savings vehicle is a type of traditional IRA for small businesses and self-employed people that allow employees to make contributions.
Basically, a Simple IRA requires that employers make contributions on an employee’s behalf (could be a dollar-for-dollar match or could be up to 3 percent of an employee’s salary or could be just a flat 2 percent.)
Simple IRAs can be a bit complicated, so be sure to read up on your IRS rules before deciding on this plan for your company. These types of plans are ideal for small business owners who want an easy-to-manage and low-cost retirement option for their employees. (Note: If you’re self-employed yourself, a SEP IRA is probably a better choice for you, since the contribution limits are larger.)
Last but not least, probably the most well-known retirement savings vehicle: 401(k)s and their ilk—403(b)s, 457s and Thrift Savings Plans (TSPs). The plans are typically offered to employees of mid- to large-sized companies, non-profits, federal, state and local governments.
As an employee, you decide how much you want to save per month and your employer then puts that amount into an account for you.
Some employers also match your contribution, up to a certain amount. (Usually no more than 6%, but it’s still free money— a total win.)
The percentage of your salary you elect to put into your 401(k) is deducted (pre-tax) from your paycheck. You then pay taxes when you withdraw that money in retirement.
This money is invested on your behalf: Your employer offers a selection of investment options, (probably mutual funds and/or target date funds.) If you leave your job, you keep your 401(k) and can roll it over into what’s known as a rollover IRA.
While you cannot take money out of your 401(k) without penalty, you can take out a 401k loan—but you are required to pay it back, or get hit with penalties, taxes, and interest.
These types of plans are ideal for someone who is working at a company or organization that matches your contribution. However, if you leave your company and are not yet vested, your employer has the right to keep their contributions to your 401(k).
An insurance product designed to provide a steady stream of income for life or for a certain amount of time, annuities are another retirement savings option.
There are two basic types of annuities: immediate and deferred. In a deferred annuity, your money is invested for a period of time, before you begin making withdrawals, which is usually about the time you reach retirement.
For immediate annuities, you begin to receive payments soon after you make your initial investment. You may consider purchasing an immediate annuity if you are close to retirement age.
However, keep in mind that there are other types of annuities, so this is one account that definitely merits advice from a trusted financial advisor. Annuities are ideal for those who have maxed out their retirement contributions (such as 401(k) plans and IRAs), and for those who are nearing retirement without a ton of savings to show for it.
When it comes to annuities: proceed with caution. Things to look out for when considering an annuity: fees, confusing features, and restrictions.
Why You Should Contribute to a 401(k)
A 401(k) retirement savings plan is one of the most popular ways to save for retirement and for good reason. It’s easy, usually rolled into other benefits you get with your job, like salary and health insurance, and also offers the potential for your employer to match your contribution. (Worth noting, if you work at a nonprofit, tax-exempt or educational organization, you will likely be offered a 403(b), which is similar to a 401(k).)
If your employer offers a 401(k), you should definitely take advantage of it. Here’s why.
Social Security Won’t Be Enough
We hate to break it to you, but many believe that Social Security may not provide enough for many people to live in during their retirement. Starting your own retirement account like a 401(k) in your 20s and 30s is a major key in living comfortably in your retirement.
For example, if you are 25 years old with a salary of $40,000 and start contributing 5 percent of your salary to your 401(k) (and your employer matches). Let’s say you get an annual raise of 3 percent, and your 401(k) earns a return of 7 percent. At age 65, you will have an estimated $1,367,094 at retirement.
But, if you wait to start contributing to your 401(k) at 30, you will save just $917,750 at retirement, a difference of nearly $500,000. That’s a big difference!
Putting it simply, if you wait to start saving for retirement, you will have to contribute a larger percentage of your income to reach your goals. So start early.
The Benefits of Contributing to a 401(k)
If you don’t know what a 401(k) is, don’t panic. There are several major benefits provided by 401(k) retirement plans. One of the major benefits is matching contributions. Many companies offer matching contributions to what you as an employee put into your 401(k) as a way to motivate employees to save for retirement.
Basically, your employer will match the percentage you put into your 401(k), up to set maximum amount. An example of this would be if your company offers you a dollar-for-dollar match of the 5 percent of your salary that you contribute to your 401(k). So, you contribute your 5 percent, your company matches the other 5 percent, making a 10 percent contribution to your 401(k).
Remember, this is free money, so anytime your employer offers retirement savings account matching, you should take advantage of it. However, keep in mind that sometimes these employer-funded matching retirement savings accounts have “vesting” periods, which means that you may not get the full match until you’ve been at your company for a set amount of time.
Compound returns are another huge benefit of a 401(k) retirement savings account. Basically, compound returns mean that not only does the money you invest earn a return, that return is also reinvested, thus earning more money. Compound interest can have a great effect on your retirement account
Another major benefit of contributing to a 401(k) are potential tax breaks. Your taxes are based on your income after you contribute to a traditional 401(k). So your taxable income decreases as you contribute to your plan. It can also potentially put you in a lower tax bracket; in addition, you don’t pay taxes on the growth/earnings of your plan until retirement when you withdraw the money.
If you’re still asking yourself, ‘What is a 401(k)?’ Consider this: The cost-effectiveness of contributing to a 401(k) savings plan is another plus. Most of the fees associated with your investment options offered to you through your employer-sponsored plan are much less than what you could find elsewhere. What’s more, employers are increasingly offering low-cost index funds that can save you even more cash, simply by avoiding the higher fees that mutual funds often charge to manage your investments.
The availability of loans is another benefit when considering whether to contribute to a 401(k). You could have the option to take out a loan on your 401(k) plan, something that isn’t available with an IRA. Depending on your employer’s plan, you could have access to up to half of the vested balance of your 401(k), for a maximum amount of $50,000.
These loans usually have a five-year term, and you are required to pay yourself back with interest. Many people utilize this option to buy a house; and in this case, the loan term can be extended to 10 years. But be sure to check with your employer, as every 401(k) plan is different. And keep in mind that if you don’t pay these loans back, it may prevent you from reaching your retirement goals.
How Can I Get My Own 401(k)?
When you first sign up or enroll in your 401(k), your employer will most likely ask you to select an amount or percentage of your salary that you’d like to contribute each pay period.
Our expert tip? Select the percentage option that automatically increases your contributions when you get a raise. Usually, employers automatically deduct the amount you opted to have set aside from your paycheck and put into your 401(k), so you most likely won’t even notice it’s gone. The limit you can contribute to your 401(k) changes each year, but in 2016, the 401(k) contribution limit was $18,000 ($24,000 if you’re age 50 or older).
If your company offers a 401(k) plan, your HR department will most likely send you information on the program when you are eligible to contribute. You may have two options: a traditional 401(k) or a Roth 401(k). Here’s a major difference: You deposit money into a traditional 401(k) with pre-tax money, while with a Roth IRA, you contribute money on an after-tax basis.
When you reach retirement and withdraw your money, traditional 401(k) withdrawals are considered taxable income. Roth 401(k) withdrawals are tax-free qualified distributions, given that the account has been open at least five years and you are older than 59 ½. Or, you could be disabled when you take the money out or the distributions will be given to your heirs when you die.
Try one of these handy calculators that can help you determine what type of 401(k) is best for you based on a number of variables. However, generally speaking, Roth 401(k)s are more valuable when you are younger and not as concerned with tax deductions.
How Much Should I Contribute?
Ultimately, this question varies depending on the lifestyle you want to have when you retire. Some like to sacrifice now and work hard to max out their 401(k)s and retire a bit earlier. For others, that’s not worth it. It’s a personal choice.
Once you determine how much money you need to have when you retire, you can use a retirement calculator to figure out how much you should be putting away monthly to reach your goals. And remember, it’s always smart to start sooner rather than later. For every year you put off contributing to a retirement plan, you will have to contribute a higher percentage later.
What Happens to My 401(k) If I Leave My Job?
If you leave your current job or have already done so, you do have options regarding your 401(k). Your first option is to cash it out. This is not an option most financial planners would recommend. If you do choose to cash it out, you will owe both state and federal taxes, as well as a 10 percent withdrawal penalty, unless you are age 59 ½ or older. So this may not be your best option.
Your second option is to leave your money in your old company’s 401(k). However, please note that some plans require a minimum amount to keep the money there. If you like the options in that plan, leaving it makes sense.
You could also move your money to an IRA. A major benefit of this option is that you have many more investment options. You could pick investments from a much broader list of mutual or index funds, ETFs, stocks, or bonds. But keep in mind that most 401(k) plans offer low-cost investments like index funds as well.
Your final option is simple: roll it over. If you go to a new company, you can take your 401(k) funds from your own company and roll it into a plan at your new company, given that they offer one. This keeps everything simple and streamlined.
What About Brokerage Accounts?
If you’re looking for a way to invest money for retirement, college, or another shorter term goal like buying a house or starting a business? Let’s assume you are already contributing (at the very least) to your 401(k) with an employer match, that you have an adequate emergency fund, then a brokerage account may be the right move for you, as it offers an option besides a 401(k) to invest in the market.
With a brokerage account, you can buy and sell stocks, bonds, mutual funds, exchange-traded funds and other types of investments, and in some instances, without paying taxes on the growth.
As the name suggests you do need a broker to open a brokerage account. However, you can make the investment decisions on your own. Depending on the type of account you and the broker you choose, the fee you pay can be as low as $5-$10 per trade.
Traditional vs. Discount Brokers
There are two different types of brokers: traditional and discount. Traditional brokers: Think Morgan Stanley, Merrill Lynch, and Wells Fargo Advisors. These types of brokers specialize in providing personalized investment advice and can offer a wide range of financial services for a premium.
Discount brokers, such as like Fidelity, Schwab, and ETrade, offer more DIY, low-cost investing services and education. Many of these types of firms have someone on hand to answer your (occasional) question, and some offer professional account managers for a fee, but the idea is to make your own investment decisions — and save money! Last but not least, traditional brokers are also beginning to offer self-directed platforms in order to stay competitive.
To get started with a brokerage account, you’ll need to have the minimum investment amount, usually, more for a taxable account and less for a 529 college savings account or IRA. However, this varies based on the broker.
Traditional brokers usually require a higher minimum and charge and annual fee, which can be waived in certain situations. Discount brokers can waive their minimum requirement if you set up automatic contributions, and usually do not require an annual fee. And regardless of the broker you decide on, be on the lookout for fees in the fine print.
Opening a brokerage account is usually easy and quick. Opening an account with a traditional broker will likely require you to meet with an advisor, in order to build a relationship. But opening an account through a discount broker can probably be done online.
Who’s Managing My Money?
Simply opening a brokerage account doesn’t mean your money is automatically invested unless you have already arranged a transfer of preexisting investments from one account to another. Think of it this way: If you’re not paying extra for a pro to trade for you, it’s your responsibility.
Keep in mind that when you make deposits into your brokerage account, the money will likely just place those funds into a money market fund, which means they will earn little interest until you buy other securities.
There is an option to set up an account that is professionally managed — but it will cost you. An advisory, or discretionary, brokerage account it just that, managed by a finance professional who will make investments and other decisions for you. These types of accounts usually require larger amounts to open, usually a $25,000 or $50,000 minimum investment. You will also pay a commission per trade, as well as an annual fee.
What About Taxes?
Brokerage accounts are taxable. However, IRAs or a 529 college savings plans benefit from a tax deferral or exemption (and in the case of Roth IRAs, if you meet the requirements.)
So, putting it simply, you will owe yearly taxes on your investments in a brokerage account, especially if you sell securities that have gained value. It’s a good idea to keep track of what you originally paid for each security in your account (also known as cost basis) and understand your capital loss or gain before selling.
How Do I Set Up Contributions?
The most optimal way to fund your brokerage account (and grow your money!) is to set up automatic transfers, usually monthly, from your savings or checking account. You can usually do this online or by calling or visiting your bank.
Another option is to set up automatic investing of your deposits into certain mutual funds, which is worth the time and effort. Taking these steps will force you to save money, and take advantage of monthly compounding interest. This will significantly increase your return over time.
The Bottom Line
When it comes to brokerage accounts, if you’re committed to boosting your savings through DIY investing or want to pay extra for the pros to do it, be sure to do your research and understand the potential costs before making any big moves.