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Retirement plans offer a lot of advantages when it comes to saving your money. Every year, I use mine to avoid paying over $10,000 in taxes and get an extra $4,000 from my employer on top of what I’m contributing (more on this below).
To choose a retirement plan, decide if you want to pay taxes today or later, when you'd like to retire, and how much you'd like to withdraw per year upon retirement. Then, choose a plan, like a 401k, Roth IRA, or a 403b.
Retirement plans also come with a lot of rules.
And it’s knowing the ins and outs of these rules that can mean the difference between a nice, early retirement (like I’m shooting for) or owing the IRS a whole lot more money than you’d probably care to part with.
How To Choose A Retirement Plan
401k Retirement Plans
401ks have become one of the most common types of retirement plans that you’ll find today. Named after the section of the IRS tax code from which it comes from, the way one works is simple:
- Every time you get paid, you’ll automatically contribute to your 401k before taxes are taken out of your paycheck.
- Those contributions get invested and have the potential to grow over time. While your savings accumulate, there are also no taxes paid on the gains you earn.
- Finally, once you retire, you can then start making withdrawals from your 401k to use for your living expenses. Taxes will then be due at the time of withdrawal.
Basically, the IRS is giving you a free pass to skip paying taxes on your income now and delay it way into the future.
To illustrate that point: If you’re in the 22% tax bracket, if you save up to the IRS maximum contribution limit of $19,500 (as of 2021), then you’ll defer approximately $4,290 in taxes.
Not a bad deal!
Guess what? If you and your spouse have a 401k, then you can both use this strategy and save double on taxes ($8,580).
If that wasn’t reason enough, many employers also will make matching contributions to their employees’ 401k plans as a way to encourage them to participate – sometimes dollar for dollar (up to a certain limit).
For example, if your employer kicks in $4,000 per year and you invest it in a stock market index fund averaging a 10% return, then these extra contributions would have the potential to grow to $657,970 after 30 years!
There are, however, a few drawbacks to using a 401k:
- You can’t make any withdrawals until after age 59-1/2 without paying taxes and a 10% penalty.
- If your employer doesn’t offer a 401k, then you can’t participate in one.
- You’re limited to only the investment options the plan administrator offers.
Between tax-deferred investment growth and employer contributions, utilizing my 401k is how I was able to grow my nest egg by over six-figures after just 5 years of participation.
Trust me – it’s an opportunity you don’t want to pass up!
403b or 457b Retirement Plans
Whereas 401k plans are designed for private-sector employees, the IRS also has two other similar plans: A 403b and 457b (both cleverly named after their corresponding section of the tax code as well).
Here's who can contribute to each:
- 403b – Public school teachers, ministers, and employees of tax-exempt organizations can contribute to a 403b.
- 457b – State, local government, and some nonprofit employers.
Generally speaking, 403b and 457b plans work nearly the same as 401k plans in terms of tax-deferment, investments, and annual contribution limits.
However, when it comes to withdrawals, 457b plans do have the advantage of letting you skip the 10% penalty if you take out your money before age 59-1/2.
Traditional And Roth Retirement Plans
Using your workplace retirement plan isn’t the only way to build your nest egg. You can also save for retirement on your own using what's called an IRA.
IRA stands for “individual retirement account”. Similar to a 401k, an IRA lets you skip paying taxes on your contributions now and instead lets you pay them when you start making future withdrawals (after age 59-1/2).
Not only is tax deferment a major advantage, IRAs can be opened with any financial institution of your choice and invested in almost anything you like: Mutual funds, ETF's, stocks, precious metals … even real estate!
That means paying fewer fees and giving you more control over what you can do with your money.
One big disadvantage is that you can only contribute up to $6,000 per year (as of 2021).
That’s significantly less than what you can put into your 401k. There are also certain income limitations about who can participate (read the full details here).
For the majority of middle class Americans, you should be able to contribute to both a 401k and IRA. Since both my wife and I use these plans, that’s how we’re able to avoid paying so much in taxes every year.
Roth-Style Retirement Plans
Tax deferment is great! But if you believe you're in a lower bracket now than you will be in the future, or just afraid taxes will go up eventually, then what you need is a Roth-style plan.
And here’s the thing … the IRS has a lot of rules for who can contribute to each type of IRA and who can’t.
For the most part, these rules are based on how much money you earn (your MAGI or modified adjusted gross income) and how you file your taxes (single, joint, etc).
Exceed any of these income limits, and IRS will basically make your decision for you.
For example, let’s say you and your spouse report a combined income of $150,000 per year.
With the Roth IRA, however, you’re good to go. As long as your MAGI is less than $196,000 as of 2020, you can make a full contribution.
Even if you earn more than this, there are some sneaky ways to still contribute like using a backdoor Roth IRA technique.
Back in 1997, a senator named William Roth proposed what would become known as the Roth IRA.
With a Roth IRA, you pay taxes on your contributions now (in the year that you make them) and when you retire in the future, you’ll make tax-free withdrawals.
The real decision behind a Roth vs traditional IRA is what you think your tax situation will be like in the future. If you think you’ll be in a higher income tax bracket than you are now, then go with the Roth.
If you think you’ll be in a lower bracket, then go with the traditional.
The other elephant in the room is that no one knows what the future holds for our tax laws.
They could go up, down, or be rewritten altogether. In this situation, it’s a classic case of “the devil you know is better than the devil you don’t know”.
By deciding to pay your taxes now, you lock-in to whatever the laws say now and liberate yourself from whatever they might become in the future.
Basically, they work the opposite of how a traditional IRA works.
Traditional IRAs
Traditional IRAs let you skip paying your taxes now and instead allow you to defer them until you’re ready to retire someday.
Roth IRAs work the opposite by taking the tax payments now and then letting you enjoy tax-free retirement distributions in the future.
According to the IRS, you can earn too much to make a tax-deductible contribution to a traditional IRA (for 2020, it needs to be less than $104,000).
Technically, you can still make a contribution to a traditional IRA. But it would be non-deductible, so that kinda defeats the purpose.
In addition, traditional IRAs are even more strict then Roth-style IRAs. Not only would you have to pay the 10 percent penalty for early withdrawals, but you’re also not even allowed to borrow any money.
That means if you choose a traditional IRA, you'll need to start withdrawing funds after you cross the age of 59-1/2. This is because the IRS doesn't want you to hold on to your savings tax free, forever.
At age 72, you'll be forced to withdraw a minimum amount of funds every year.
Failure to make an RMD, (required minimum distribution) could result in a 50% tax on the amount you were supposed to take out.
Since Roth IRAs are already taxed money, you won't have this problem. You can withdraw funds at any time, even before 59-1/2, and will never have a minimum distribution amount.
Small Business Retirement Plans
If you work for yourself, for a very small company, or do any kind of side hustling, then you might also be able to participate in one of the following:
Solo 401k
A solo 401k is for business owners that have no employees (spouses excluded).
It more or less works the same as a regular 401k plan except that you can contribute as both the employer and employee (since you’re technically both) – up to an astonishing $58,000 (as of 2021).
Contributions can count as a tax deduction against your personal taxable income or business.
SEP (Simplified Employee Pension) IRA
SEP IRAs are for businesses with little to no employees. Similar to the Solo 401k, a SEP IRA can give you the incredible advantage of contributing as both an employer and employee (if you happen to be both).
For the employer part, you can save up to the lesser of 25% of your compensation or $58,000 (as of 2021). That means reducing your taxable business income by as much as 25%.
SIMPLE IRA
SIMPLE IRAs are designed for companies that are too small to have a 401k plan but too big for a SEP IRA (1-100 employees). Employees are allowed to save as much as $13,500 per year (as of 2021).
However, employers can also contribute on your behalf.
Choose A Retirement Plan That Works For You
When it comes to building your wealth, there’s a lot of money to be made by utilizing your retirement plans as much as possible.
Between deferring your taxes, employer contributions, and potentially offsetting your business income, every dollar you contribute is working much harder for you than it normally would in a typical savings or brokerage account.
However, not all types of plans are for everyone. There are lots of rules about who can participate and how much they can contribute.
The best thing you can do is to read up, ask for advice, or then decide which ones are going to best help you to achieve your financial future.
