When saving for retirement, one of the best things you can do is do it from all angles. In other words, use all available retirement accounts and take advantage of the tax breaks that come with them. As you plan for retirement, these three accounts can be your heroes.
1. A 401(k) plan
A 401(k) is the most popular type of retirement plan, primarily because it is offered by employers. With a 401(k), you make pre-tax contributions, which reduce your taxable income for the year and set the money aside for retirement before you can “see” it. When you set up your 401(k) plan investments, you’ll be given options to choose from, typically your company’s stock (if it’s a public company), index funds based on market capitalizations, and target date funds that are automatically rebalanced as retirement approaches.
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Beginning in 2022, the most you can contribute to your 401(k) annually is $20,500. You can make a catch-up contribution if you are age 50 or older, which allows for an additional $6,500. You must be age 59½ to make penalty-free withdrawals from your 401(k). If you withdraw money before that date, you will have to pay income taxes and a 10% early withdrawal fee.
Even if you don’t want or need to, you must take required minimum distributions (RMDs) once you turn 72. Otherwise, the IRS imposes severe penalties.
If your employer offers a 401(k) plan, use it without a second thought. It is a main source of retirement income for many people.
2. Roth IRA
Where a 401(k) plan may fall short, IRAs take much of the work. Unlike a 401(k), IRAs are not tied to an employer and must be opened by you, similar to opening a regular bank or brokerage account. They also work like brokerage accounts in that you can invest in any stock you want; you don’t have to rely on the options provided to you.
What makes Roth IRAs so great is that your money essentially grows and compounds tax-free; you contribute after-tax money to a Roth IRA and withdrawals are tax-free in retirement. Depending on how much you accumulate in a Roth IRA, having tax-free withdrawals in retirement can easily save you tens of thousands of dollars in taxes.
the maximum amount you can contribute to an IRA (both Roth and traditional combined) is $6,000. If you contributed $6,000 a year to your Roth IRA and received an average 10% annual return over 25 years, you would have more than $590,000. The difference between doing that in a Roth IRA and a brokerage firm is that in a Roth IRA, all that money would be yours; in a brokerage account, the $440,000 in capital gains would be taxed.
If you’re early in your career and this is likely to be the lowest tax bracket you’ll find yourself in, it makes sense to pay taxes on your contributions now instead of later, when it could be more expensive. Roth IRAs also have income limitsso take advantage before you earn more than your eligibility.
3. Traditional IRA
Traditional IRAs work like Roth IRAs, but the only thing that essentially sets them apart is when you get your tax break. With a traditional IRA, you get your tax benefits up front and the opportunity to deduct some or all of your contributions. Your eligibility and the amount you can deduct depend on your income, marital status, and whether you have a retirement plan at work.
Like a 401(k), traditional IRAs also have RMDs, and you can count on Uncle Sam wanting his cut. Since you got tax-exempt early on, the IRS forces you to take RMDs so it doesn’t turn into a situation where you get two tax breaks: one with the deduction and one by not paying taxes at retirement.
If you’re at the height of your career and this is likely to be the highest tax bracket you’ll find yourself in, it makes sense to take tax relief now, when it’s most valuable, rather than waiting until later when your tax bracket is lower. it will. it’s probably less.
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