We've all heard the warnings and are well aware that we should save more for retirement. And as a new year approaches, it's a good time to resolve to take concrete steps to do just that.
Uncle Sam wants you to save for retirement so much that the federal government has created a number of tax-advantaged retirement accounts, including popular choices such as the 401(k) and individual retirement account.
For most people, especially young people, the best place to start is with the 401(k) program at work. This is a particularly enticing option if your employer matches a portion of your contribution. That's essentially free money.
"If you're working at a company that offers a 401(k) and they match contributions, you should really save in that plan," says Wei-Yin Hu, vice president of financial research at Financial Engines, an independent investment advisory firm in Sunnyvale, California. "It's a great way to get a really good head start on building your retirement savings."
If you're self-employed, you have even more options, some of which allow significant tax savings. Exactly which option, or combination of options, is best depends on your personal financial situation. "There's a category of people who are self-employed or own their own businesses and have more complicated choices to make," Hu says.
This is a good time of year to consult your accountant. High earners may also want to engage a financial planner to discuss the best strategy.
Not only do you need to figure out which kind of account to use, you also need to pick a financial services company to handle your accounts, unless your employer picks one for you, and then choose investments. If you can't afford a financial advisor, see what free advice is offered by the company that holds your money. Be aware that all accounts come with fees, and higher fees can eat into your returns.
"If you have a very long time horizon, you can afford to take some risk for higher growth," Hu says. But you want to select "the right funds so your exposure to the market is diversified."
More people are being offered something that they may not recognize as a retirement savings tool: a health savings account. These accounts are usually coupled with a high-deductible health insurance policy. Not only can choosing such a plan lower the cost of your insurance plan, it can help boost your retirement savings, along with your 401(k) or IRA.
"What a lot of folks don't realize is both of these tools can help you save for retirement," says Steve Christenson, executive vice president of Ascensus in Brainerd, Minnesota.
You can use the money in your HSA for doctor visits, contact lenses and medications not covered by insurance. But that's not your only option. You can also pay those expenses out of pocket and leave the money in your HSA to grow. If, at some point, you need money, you can be reimbursed for past expenses. "Essentially, those dollars grow on a tax-deferred basis," Christenson says. "It can actually turn itself into a very good retirement account."
The Internal Revenue Service has its own set of complex rules for each type of retirement account. Some tax breaks are only available to people at certain income levels, so what we're giving you here is a basic overview. Check with the IRS website or your accountant for details.
All these accounts allow your money to grow tax-free. You pay tax when you withdraw the money, except for Roth IRAs, where no tax is due at withdrawal. If you withdraw money before you reach age 59 1/2, in most cases you will have to pay a 10 percent penalty in addition to regular income tax.
Here are seven types of retirement savings accounts to consider:
401(k) or 403(b) offered by your employer. For most people, this is the easiest and best place to start investing for retirement. The money is withheld through payroll deduction, and you can save up to $18,000 of your pretax income in 2015 ($24,000 if you are 50 or older). If you leave your job, you can roll the account over into a new employer's 401(k) or your own IRA. A 401(k) is usually offered by a for-profit company, while teachers and other employees of nonprofits may be offered a 403(b) instead.
Solo 401(k). A sole proprietor can set up an individual 401(k) and make contributions as both the employee and employer, up to a total of $53,000 in 2015 (or $59,000 for someone over 50).
SEP IRA. SEP stands for simplified employee pension, and this kind of account is used primarily by the self-employed or small business owners. As the employer, you can contribute up to 25 percent of your income or $53,000, whichever is less, in 2015. These accounts are easier to set up than a solo 401(k). If the business has employees, the employer must contribute for all who meet certain requirements.
Simple IRA. This plan allows small employers (fewer than 100 employees) to set up IRAs with less paperwork. Employers must either match employee contributions or make unmatched contributions. An employee can contribute up to $12,500 in 2015, with an extra $3,000 allowed for those over 50.
IRA. Anyone can contribute up to $5,500 a year to an IRA ($6,500 if you're over 50). The money grows tax-free. You can contribute to both an IRA and a 401(k), but if you're covered by a retirement plan at work, you can't deduct your IRA contributions from your taxable income if you earn more than $71,000 annually (for single filers) or $118,000 (married filing jointly). After earning $61,000 and $98,000, respectively, you get only a partial deduction. If you're not covered by a retirement plan at work, you get the full deduction no matter what your income, unless you file jointly with a spouse who has a retirement plan at work.
Roth IRA. With a Roth IRA, you are contributing after-tax dollars, and you get no tax deduction for your contribution. The money you earn grows tax-free, and you pay no tax on withdrawals after you reach 59 1/2. Plus, unlike with regular IRAs, there is no mandatory withdrawal at age 70, but you can withdraw the amount you contributed (but not your earnings) at any time with no penalty or no taxes due, which is not the case with traditional IRAs. To contribute to a Roth IRA, you must make less than $131,000 (if you're single) or $193,000 (if you're married filing jointly). If your income is more than $116,000 (single) or $183,000 (married filing jointly), your allowed contribution is reduced. You can contribute to both a Roth IRA and a traditional IRA, but the limits apply to your total contribution. Some people who make too much to contribute to a Roth IRA contribute to a conventional IRA and convert it into a Roth later.
Health savings account. Those with certain high-deductible health insurance plans can save money tax-free in a HSA. You can contribute up to $3,350 a year for an individual or $6,650 for a family. If you're 55 or older, you can contribute $1,000 more. You can withdraw money from your account to pay allowable medical expenses, including copays and items such as eyeglasses. If you don't spend the money, it rolls over indefinitely. Once you're 65, you can withdraw money for any reason without penalty, but you have to pay income taxes on money you withdraw. Or, you can use it for retiree medical expenses tax-free. If you withdraw the money before you're 65 for any reason besides medical expenses, you have to pay taxes and a 20 percent penalty. But as long as you save your receipts, you can withdraw money to reimburse yourself for expenses you paid years ago. If you don't need the money for medical expenses, you can invest it as you would other retirement savings.
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