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There are a number of options available when it comes to retirement accounts. It can be hard to keep track of the differences between them and what to keep track of what your contribution limits are. No matter what type of retirement accounts you choose, my advice is to save early, and often. Time in the market has a much bigger impact (through compound interest) than trying to time the market.
Here are the 4 most commonly known retirement savings accounts available:
401k and Roth 401k
The most common retirement accounts are company sponsored 401k retirement savings accounts. You fund a traditional 401k account through payroll deduction, before taxes get taken out. Your contributions lower your taxable income and lower the total amount of taxes you pay annually.
Some employers are now offering a Roth 401k, which combine the benefits of Roth IRA and 401k. Contributions to a Roth 401k go in after you have paid taxes. The money invested then grows tax free instead of tax-deferred like a traditional 401k.
*Tax-deferred money means you don’t pay taxes on it until you start withdrawals. Withdrawals count as taxable income. *
You can start withdrawing money from both types of accounts after 59 1/2 without a penalty. You’ll be obligated to take minimum withdrawals after you reach age 70 1/2.
In 2019, the maximum allowed contribution for workers into a 401k is $19,000 (for people under 50). People that are 50 and over can add an additional $6000 in “catch up” savings. This brings the maximum contribution allowed to $25,000 for people 50 and over.
Many companies offer to match your contributions to your 401k (generally around 5%). Matching contributions from your employer do not count towards the $19,000 or $25,000 maximum contribution allowed by the IRS in 2019.
That’s why you should always max out your contribution and take advantage of your company match.
|Traditional Accounts||Roth Accounts|
|Contributions made with pre-tax dollars||Contributions made with after-tax dollars|
|Withdrawals (principle & interest) are taxed||Withdrawals (principle & interest) are tax-free|
|10% early withdrawal penalty applies to the entire balance||10% early withdrawal penalty only applies to gains, not deposits|
Roth IRA and IRA
What’s the difference between a Roth IRA vs a traditional IRA? The biggest difference is when you pay taxes. A traditional IRA’s contributions are tax-deductible in the year they are made. The tax advantage of a Roth IRA is that your withdrawals in retirement are not taxed.
How do you choose which investment vehicle is best for you?
If you expect your tax rate to be higher in retirement, a Roth IRA is the best choice because you’ve already paid taxes on the money invested. Any withdrawals will not be counted as taxable income.
If you expect your tax rate to be lower in retirement, a traditional IRA may be the better choice for you. Your contributions to a traditional IRA are tax deductible (both federal and state) but you will have to pay income tax when you withdraw money in retirement.
|Traditional IRA||Roth IRA|
|Contribution Amount||$5,500; $6,500 if you’re over 50 years old||$5,500; $6,500 if you’re over 50 years old|
|Age Restrictions||Once you hit 70 ½ years old, you can no longer contribute||None|
|Income Restrictions||None||Must make less than $135,000 per year|
|Taxes||Contributions are tax-deductible||Tax-free withdrawals|
|Withdrawals||Required minimum distribution at 70½||You can withdraw your money (tax-free) at any time after 59 ½|
|Roth 401k||Roth IRA||Trad. 401k||Trad. IRA|
|Taxed at withdrawal||No||No||Yes||Yes|
|Early withdrawal penalty||On earnings only (before age 59 1/2)||On earnings only (before age 59 1/2)||Yes, before 59 1/2||Yes, before 59 1/2|
|Mandatory withdrawal age||70.5||No||70.5||70.5|
|2018 contribution limit**||18500||5500||18500||5500|
|Income limits||No||Yes||Yes||On deductions|
After you max out the contribution limits to your retirement accounts, you should start looking into acquiring other assets that provide a source of income like real estate (crowdfunding, flipping, rentals, etc.), create intellectual property/royalties, and peer-to-peer lending as examples.
Maxing out your contribution limits can take a lot of sacrifice but is the smart thing to do to take advantage of compound interest.