Retirement Plans 101: Three Rules to Help You Understand the Basics
In honor of playoff baseball and Big Papi's first season of retirement...
If there is one thing the investment industry is great at, it’s making everything seem more confusing than it needs to. Retirement plans are no different. This link to the IRS website lists 15 different types of retirement plans, and there are even more beyond this list.
Whether it’s an IRA (Individual Retirement Account), Roth IRA, SEP IRA, 401k, 403b, or others, there are a few general rules of thumb you can use to help you understand how most of these plans work.
Rule 1: Remember the age 59.5.
Most retirement plans don’t allow you to take money from the plan before age 59.5 without incurring a 10% penalty AND paying taxes on that withdrawal at your ordinary income tax rate. What does that mean? Let’s say you withdraw $1,000 from your plan at age 40 for an emergency car problem, and your income level currently puts you in the 28% tax bracket. That means you pay a 10% penalty, or $100, and you are taxed at 28% of that $1,000, or $280. So, instead of having $1,000 to pay for that car problem, you now have $620.
Rule 2: The government will get theirs.
Yes, there are absolutely tax benefits of using retirement plans, BUT rest assured Uncle Sam isn’t letting you get away entirely tax-free.
What it boils down to is you have two choices when you pay the government, now or later. In the case of a Roth IRA, you contribute after paying taxes. No matter how big the account grows, in the government’s eyes they already got theirs, so you don’t pay tax on any gains in the account. You can do some serious tax-free damage if you hold on to a Roth for a couple decades.
Open a Roth if you don’t have one.
In the case of an IRA or 401k, all the money that goes into the account is put in before taxes are taken out, aka pre-tax dollars. Therefore, you guessed it, when it comes time to take money out of the account (remember 59.5), you pay taxes at whatever your income tax rate is at the time of disbursement. For those who expect their income to be much less in retirement, and therefore a lower tax rate, it makes sense to pay taxes later at the lower rate.
Rule 3: There are limits
In all situations, the IRS limits how much money you can tuck away for retirement. Remember, they give the tax breaks, they govern the plans, so they make the rules. There are employer and employee contribution limits as well as individual limits for individual accounts. It gets complicated when you explore all the options (SEP IRA, SIMPLE IRA, etc), but here are the most common limits:
IRA and Roth IRA: $5,500/year, $6,500/year for those 50 and older
401k and 403b: $18,000/year, $24,000/year for those 50 and older
Again, other plans have varying contribution limits, but these are the most common plans and therefore the most noteworthy.
As I said, there are many more components to retirement plans, but for you, the one contributing to the plan, these are essential rules to understand. It will help demystify the investment jargon accompanying retirement plans.