You probably know the different types of retirement accounts, but do you really know how they work, what their tax implications are, and how they differ from each other?
It can quickly get confusing if you don’t know all of the details. The right choice can become unclear. That’s why we’ve put together a breakdown and summary of six common types of retirement accounts: so you can be informed when it comes to your retirement income options.
Odds are, you have a 401(k), and you know what it is: a retirement savings plan sponsored by an employer. Most employers these days offer a 401(k) plan to their employees and match contributions up to a certain percent. So, if you contribute 3% of every paycheck to your 401(k), your employer contributes 3%, too. This helps your 401(k) grow quicker, and the money that you contribute isn’t taxed before it goes in.
But the money in your 401(k) is not considered guaranteed, because your funds can be invested in the stock market, so it’s subject to some market volatility. That means there is some inherent risk to the amount of funds in your 401(k), depending on your overall investment strategy.
Traditional Individual Retirement Accounts (IRAs)
Unlike a 401(k), traditional IRAs aren’t employer-sponsored. Instead, they’re are an individual retirement account that provides income in retirement. When you make a contribution, it’s usually fully tax-deductible, depending on your circumstances, and you can make annual contributions to IRAs that are tax-deductible. However, when you withdraw your money, you do pay taxes. Keep in mind that by the time you retire, tax rates may be higher than they are now. So, it comes down to when you want to pay the taxes.
One thing to keep in mind: you can lower your taxable income now by funding an IRA. This can help you save money on your taxes while you’re working, because you’ll most likely be in a higher tax bracket now. Then, when you’re retired, you’ll generally be in a lower tax bracket when you start taking distributions from your IRA.
Roth IRAs are the opposite of traditional IRAs. Instead of paying taxes on withdrawals, you pay taxes on contributions you make to your Roth IRA. But, when you withdraw money, you don’t pay any taxes. That means you can have a retirement without worrying about taxes. Doesn’t that sound nice? Another benefit is that your earnings grow tax-free, too. You pay the taxes up front, but you may be thankful in the future if tax rates start to rise.
Keep in mind that by the time you retire, tax rates may be higher than they are now. So, it comes down to when you want to pay the taxes.
An annuity is a financial product designed to help protect you from potentially outliving your income. It’s also a way to get income for life, because your premium payment into the policy can be converted into payments that can last for life. In other words, it helps ensure that you won’t run out of money in retirement.
Annuities are typically used as part of a larger retirement strategy. You pay the insurance company a premium or premiums, depending on the type of annuity you’ve chosen. These premiums accumulate and earn interest over time. Once you choose to receive the income, usually in retirement, you tell the insurance company to pay it as a lump-sum or monthly, quarterly, or annually. There may be some restrictions on the frequency of the payout, depending on the annuity you choose.
There are many types of annuities: immediate, deferred, fixed, and variable, and they all operate a little differently. With immediate annuities, payouts begin shortly after the contract goes into effect and your current tax rate applies to those payouts. All deferred annuities—annuities that do not begin making payments immediately—are tax-deferred, and you won’t pay taxes while your annuity is growing. Taxes are only paid when you take money from the annuity. Once you retire (and no longer receive a regular paycheck from your employer), your tax rate may be lower, so you may end up paying less taxes on this money.
Fixed annuities guarantee a set rate of interest and protect your annuity savings from investment market losses. There are two kinds of fixed annuities: Fixed rate and fixed indexed. Fixed rate annuities declare the interest rate in advance and guarantee the rate for one or more years. Fixed index annuities allow you to participate in the market growth, but prevent any losses when the market goes down.
Variable annuities let you participate indirectly in the market through the purchase of sub-accounts, which invest in mutual funds. You can experience both gains and losses depending on the performance of the investment options (sub-accounts) you have chosen. While you can suffer losses to your variable annuity savings, many variable annuities offer options (at additional cost) to help protect your savings from losses.
Even though they aren’t as common as they used to be, many government and union employees still have a pension—a defined-benefit plan that is provided by private and public employers. That means the benefit (or payment amount) you receive is fixed, making it another form of guaranteed income that you get for life. Depending on the pension plan, the payments may even continue to a spouse or designated survivor. Pensions are easier to manage than a 401(k), but your funds aren’t readily available.
As far as pension taxes go, most often, pensions are funded with pre-tax dollars. That means you probably will have to pay income tax on your pension funds.
This one isn’t talked about as much when it comes to retirement, but emergency funds are still important even after you stop working. Poor health, medical expenses, loan repayments, home repairs, and family emergencies can derail a person financially for months or even years. That’s where an emergency fund can come in handy. Emergency funds should be easy to access for whenever you need it.
All of these different kinds of retirement accounts can be essential to planning for your retirement, and can help you live the retirement you want. Knowing the differences between them and how taxes affect them can help you maximize your retirement savings. To take your retirement savings a step further, consider talking to a financial professional to help manage your accounts and work together to create a solid plan for your retirement.
Income from a Roth IRA is tax-free if withdrawals are taken after age 59 ½ and the account has been open for at least five years.
Annuities are long term financial products designed for retirement income and may not be suitable for everyone. They involve fees, expenses and limitations, including surrender charges for early withdrawals. Some include optional riders and benefits that may come at additional cost. Annuity product and feature availability may vary by state.
Annuity guarantees are backed by the financial strength and claims-paying ability of the issuing company, and for variable annuities, do not apply to the performance of the variable sub-accounts which will fluctuate in value. Withdrawals are subject to ordinary income tax, and if take prior to age 59 ½ may be subject to an additional 10 percent federal penalty.
This article is designed to provide general information on the subjects covered and is not intended to provide specific legal or tax advice.