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The United States tax laws allow for what is called an Individual Retirement Arrangement. Most folks call this an Individual Retirement Account, or "IRA" for short. "Individual" means that it only has one person as its owner. "Retirement" refers to the account's purpose, which is saving and investing for the wealth you will need to sustain yourself after your career. There are two types of IRAs: Traditional and Roth. You can only contribute to a retirement account if you or your spouse has an earned income, meaning income from employment or operating a business. Passive income such as interest, dividends, or Social Security payments are not considered earned income. Visit the IRS website to learn more about what is considered earned income. You can invest the assets in a retirement account in a variety of ways, but there are some investment products that are ineligible for retirement accounts. With some exceptions, you cannot access the funds in a retirement account before turning age 59 1/2 without suffering a penalty from the IRS.
The most common IRA is a traditional IRA. A traditional IRA allows its owner to contribute money to the account and deduct the contribution from their taxable income. For example, if you make $50,000 per year in gross taxable income, and you contribute $5,000 to a traditional IRA, then you will deduct the $5,000 from your gross taxable income and only be taxed on $45,000 in income. The assets within a traditional IRA are not taxable, meaning that any gains, interest, or dividends are not taxable so long as the assets are contained in the traditional IRA. When you take distributions from the traditional IRA in retirement, the distributions are taxable as regular income. A lot of people will refer to a traditional IRA as a "tax-deferred" account, because you don't pay tax on the money contributed today, but you will pay taxes later in life when you withdraw money from the account.
Roth IRAs are named after Senator William Roth, who authored and sponsored the legislation that led to the creation of the Roth IRA in 1998. Roth IRAs are different from traditional IRAs. Contributions to a Roth IRA are not deductible from your taxable income. Most people refer to these contributions as using “after tax dollars”. Similar to a traditional IRA, the assets within a Roth IRA grow tax-free. The distributions from a Roth IRA are also tax-free, since the assets were taxed before they were added to the account. In 2006, the Roth 401(k) Plan became available for businesses to offer to their employees.
This can be a more favorable account compared to a traditional IRA because the taxes you pay on the money you contribute to the account can result in less taxes paid overall because the money could grow to substantially larger values. The traditional IRA allows you to reduce your tax liability on the front end, but will cost you in taxes later in retirement. And, if your account grows significantly in the time between your contributions and your retirement, you could potentially pay more in taxes.
Now that we’ve established the difference between a traditional and Roth IRA, let’s take a look at employer-sponsored retirement plans.
Most workers have the opportunity to contribute to a retirement plan offered through their job. The most common form is known as a 401(k). There are many others, but for the most part they function in similar ways. The companies who sponsor these plans can offer the plans in a traditional or Roth arrangement. Most often, the plan will only offer a traditional IRA account.
The 401(k) retirement plan and most other plans are attractive because they include an employer-matching contribution up to a certain percentage of the employee’s compensation. The company will match your contributions dollar-for-dollar up to a stated percentage of your income. Commonly, the percentage is about 3-4%, though many companies offer much more. You can contribute more than the matching percentage to your retirement account, but you will not receive the matching contribution from your employer beyond the stated percentage.
David is an employee of XYZ Toy Company. XYZ Toy Company offers a 401(k) retirement plan to its employees with a 5% match. David's paycheck before taxes and any withholding is $1500. The company will match all of David’s contributions to his 401(k) account up to 5% of his gross pay ($1500), or $75. David decides he will contribute $100 of his paycheck to his retirement. The company match is limited to $75, so each paycheck David contributes $100 to his retirement account and the company contributes $75 for a total of $175 of contributions.
There are contribution limits to retirement plans, and they vary based on the type of plan or account, so consult your retirement plan sponsor to inquire about the contribution limits. Most retirement plans will require a certain minimum time of employment, most often one year.
Also, many plans will require a vesting period. This means that the employer’s contributions to your account will only be permanent if you stay employed with that company for a period of years. The most common vesting period for a 401(k) that we’ve seen is five years, with a graduated vesting percentage each year. This means you must remain with the company and have participated in the retirement plan for five years before you are able to keep all (100%) of the employer’s contributions to your retirement. After one year of employment and participation in the plan, you are considered to be 20% vested, meaning that if you left the company or terminated your participation in the plan, then you would only keep 20% of the employer’s contributions to your account. This allows for the company to incentivize you to stay in their employ for a period of time. The employee’s contributions cannot have a vesting requirement, so your contributions are always 100% yours.
After careful planning, you can determine what portion of your overall income you want to contribute to retirement. We strongly recommend eliminating any non-mortgage debt (i.e., auto loans, student loans, credit card debt) and building up a personal savings account for emergencies. Retirement accounts are wonderful, but you can’t access the funds in the account without being penalized (with a few exceptions). So, it’s best to have some money set aside for emergencies that you can access for those unexpected events that life brings you. Once you have built up a sufficient emergency fund and eliminated all non-mortgage debt, then you’re ready to start building your retirement. We generally recommend contributing about 10-15% of your gross annual income to retirement accounts.
You may also want to consult a tax advisor to determine the best course of action based on tax advantages and consequences.
We hope you enjoyed this post, and if you'd like to learn more, be sure and check out our next post about optimizing your retirement contributions. Call or email us, and we can schedule a time to visit about saving for your retirement.
This communication is designed to provide accurate and authoritative information on the subjects covered. It is not, however, intended to provide specific legal, tax, or other professional advice. For specific professional assistance, the services of an appropriate professional should be sought.