Unfortunately, we live in a time where most jobs do not pay a pension. Instead, we as individuals have to pay for our own retirement. If we get on it right away, and do it correctly, then it’s not a problem. However, if you make mistakes early on, or don’t save for retirement until much later in your life, it’s going to be very difficult for you to retire comfortably. Alternatively, if you do want to live comfortably, you’ll have to invest a substantial amount of money to make up for not investing earlier.
When it comes to retirement accounts though, not only is there a lot that you should know, but there are a lot of individual accounts as well. There are 3 main ones that you should know about, which including the 401k, IRA, and HSA. Of course, there are Roth accounts for the 401k and IRA as well, but for this article, I’ll consider the the same as the account itself is the same, just the way you pay taxes are different.
The 401k is probably what most people have heard of. Employers that do offer any sort of retirement account will generally put it inside a 401k. For any money that’s put inside a 401k account, it is reduced from your taxable income. The 401k has a yearly maximum contribution of $19,000, with it being bumped up to $25,000 after the age of 55. With a 19,000 limit, that would mean you would be able to put aside $730 a paycheck (if you’re paid every 2 weeks) before hitting the limit.
Because the plan is tied to your employer, there are a few drawbacks, including limited investing options, and higher fees. That’s not to say you shouldn’t invest in a 401k though! Even if you don’t have a great plan right now, if you switch employers, you can roll over your contributions to the new employers plan without any sort of penalty.
The 401k is set up to not allow any sort of withdrawals until the age of 59.5. If you do have to take money out for any reason (this should be a last resort), there are a few penalties for doing so. First, the IRS will take an automatic 20% of the withdrawal, second, you’ll be subject to an early withdrawal fee of 10%, and finally, you’ll lose the ability for that money to accumulate in the account.
There are a couple of covered ways that you can withdraw some money and avoid paying the penalty. These including taking equal payments, you leave your job, you have to divide the 401k up in a divorce, you become disabled, you are making a rollover contribution, you died and needed to pay a beneficiary or estate, the money paid for an IRS levy, you became a victim of disaster and the IRS granted relief, if you over contributed, and finally, if you were an active duty member and got called to service.
Individual Retirement Account – IRA
If you either don’t have a 401k offered at your place of employment, or if you’d like to contribute more with more options, you can open up what’s called an Individual Retirement Account, or IRA. The IRA has a yearly maximum contribution of $6,000, with a catch up contribution of $7,000 if you’re above the age of 50. Like the 401k the money you put inside your IRA is tax deductible. The main difference between the two accounts is that you are not stuck investing the way your 401k plan tells you to. You can pick the way you’d like to invest, and generally, there are lower fees when you go with that kind of approach.
Being an account that it primarily used for retirement, there are also very similar penalties for taking the money out before the age of 59.5. However, there are different exceptions where you can avoid some of the taxes.
Medical expenses (more than 10% of your adjusted gross income), healthcare insurance payment (if you received compensation for 12 consecutive weeks), disability (if you cannot do any gainful activity because of physical or mental condition, requires doctor verification), inheriting an IRA ((from non-spouse (doesn’t matter the age) if its from you spouse, and you chose to title as inherited IRA), 72T Payments ( substantially equal periodic payments (SEPP)),qualified higher educational expenses (for yourself, spouse, children, grandchildren), first time home buyer ($10,000 max, up to 120 days), and finally reservist distributions (ordered or called after September 11th, more than 179 days
Health Savings Account (HSA)
The sort of newer account that you should really take advantage of the is the Health Savings Account. The Health Savings Account is a very powerful account that is intended when you need to pay for healthcare. Anything from doctor visits, co-pays, medication and other expenses can be covered with this account. The account has a $3,500 yearly contribution limit.
The powerful part about this account is that you can actually invest the money that you contribute. Because it is tax-incentivized, you do not pay taxes when you put money in, when it makes money inside of the account, and if you take money out for qualified health expenses, you don’t pay taxes either. If you thought that wasn’t enough, when you turn 65, you are able to take money out of the account for any reason without penalty.
If you chose to use the money inside of the account for a health related expense, you’ll need to keep a receipt to show proof to the IRS that you used the money for a health related expense.
Ideal Strategy Summary
While it would be nice to max out all of these accounts (and if you have the money, you definitely should), here is a roadmap of the way you should prioritize the different accounts.
- Match your Employer’s contribution to your 401k account
- Max out HSA ($3,500 per year)
- Max out IRA ($6,000 per year)
- Max out 401k ($19,000 per year)
In reality, you can alternate between maxing out the HSA and IRA. In my opinion, the HSA offers a much better deal, and due to the lower maximum contribution limit, it’ll be easier to max out anyway. Whichever you decide to do, the first step should definitely be matching the 401k contribution that you employer gives you (it’s free money! Take it every time). Once you’ve got both HSA and IRA maxed out you should move to max out your 401k.
If you’re able to contribution that much within a given year, congratulations! You can invest any extra money in any other way you see fit.
No matter which way you’d like to contribute to your retirement accounts, the important thing is that you do decide to go ahead and contribution what you can afford. As you move throughout life, the money you’ve invested in these accounts will work for you in ways that you wouldn’t believe. It’s no coincidence that Einstein said that compound interest is the 8th wonder of the world!
What is your retirement account strategy? Let us know down in the comment section below