Types of Retirement Accounts Explained and Simplified

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If you are struggling to understand the different types of retirement accounts available for you to invest in, you’re not alone. While most people have heard of a 401(k) plan, not everyone knows the difference between a traditional 401(k) and a Roth 401(k). The good news is you don’t need a degree in finance to understand the various types of retirement accounts.

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3 Primary Types of Retirement Accounts

Lets break down the most common ways retirement accounts are opened. 

  1. Through a company you work for
  2. Through yourself, if you’re self employed
  3. With a financial institution on your own

If you’re a super rock star who has a full time job and a profitable side-hustle, you could have accounts open for all 3 scenarios. However, most of us fit into 1 or 2 of the scenarios.

For over ten years, I only put money into a 401(k) with the company I was working for. This past year I maxed out my 401(k) contributions for the year, so I opened a second account with Vanguard to put additional money towards my retirement savings.

That said though, there is no need to wait until you are maxing out your contributions in a company sponsored or self employed retirement savings account before opening a retirement account directly with a financial institution, like Vanguard.

Steps To Help Determine Which Retirement Accounts To Invest In:

  1. First, take full advantage of any match program available to you through a company sponsored account
  2. Then, take some time to understand how well your company sponsored or self employed retirement savings account is performing
  3. Next, compare that to other leading financial institutions
  4. If you can get a better Return on Investment (ROI) by opening an individual retirement account (IRA) with a financial institution, then max out your IRA first.

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Traditional Verses Roth Retirement Accounts

Regardless of how your retirement accounts are open, you have two ways to invest your money within a retirement account (traditional or Roth). The main difference between these investment types is when you’re taxed.

When investing in a traditional or Roth account is it important to consider what your tax rate is today verses what it will be in retirement.

The younger you are the greater the chance you will be in a higher tax bracket when you retire. As you get older you can often afford more (a nice home, new car, etc.), so your expenses gradually go up. This means you might need more to live on when you retire verses right out of college.

Traditional Retirement Account

A traditional account is where the money you invest now will not be taxed until you withdraw it. When you receive your W2 at the beginning of the year, it will show your taxable income as your total earnings less the amount you put towards your traditional account.

Roth Retirement Account

A Roth account is where the money you invest now is taxed at your current tax rate. When you withdraw these funds you will not be taxed.

Types of Company Sponsored Retirement Accounts

#1 – 401(k)

Most larger companies offer a company sponsored 401(k) retirement account. This is where an employee (you) sets up a 401(k) account. Then, the company and the employee make contributions toward the employees retirement account.

Companies often contribute up to a certain percent of what an employee contributes to their 401(k) each year. At a minimum, you want to make sure you are contributing the amount your employer will match. Otherwise, you are throwing away free money.

#2 – 403(b)

Similar to a 401(k), a 403(b) is a retirement savings account for tax exempt employees. This would include teachers, doctors, nurses and government employees.

#3 – 457(b)

This is also similar to a 401(k) and is offered to state and local government employees like firefighters or police officers. In some cases, teachers and doctors may also get this option.

The greatest advantage this retirement account has over a 401(k) or 403(b) is you won’t be hit with a 10% penalty if you withdrawn funds before the age of 59 1/2.

Types of Self-Employed Retirement Accounts

#4 – Solo 401(k)

This is an individual 401(k) plan for someone who is self-employed and does not have any employees. An individual’s spouse is the only other person that can be on this plan.

You must have an employer identification number (EIN) to open this type of retirement account. The contribution limits are significantly higher then a 401(k) contribution limits.

#5 – SEP IRA

A Simplified Employee Pension IRA (SEP IRA), is ideal for individuals or small business owners. The main drawback is the contribution amount a business owner puts in for their retirement has to be the same contribution amount they put in for their employee.

Like the Solo 401(k), an individual can contribute a lot more towards their retirement account per year than an employer sponsored plan allows. However, the max contribution amount cannot exceed the IRS limits or 25% of the year’s compensation.

Other Types of Retirement Accounts

#6 – Individual Retirement Accounts (IRA)

This is where you open a retirement savings account on your own through a financial institution. An IRA provides similar tax advantages that a company sponsored or self employed retirement program offers. For 2020, the contribution limit is $6,000.

#7 – Health Savings Account  (HSA)

An HSA is a wicked sweet way to save for retirement.  Everyone who has access to a Health Savings Account (HSA) should be maxing out the full contribution limits every year if they can.  This type of account offers some amazing benefits.

#8 – Brokerage Account

A brokerage account can also be a type of retirement account. The main difference between a brokerage account and the others referenced in this article is there’s no tax advantages. You will pay taxes on earnings the year they are realized. Additionally, you will have to pay taxes on any capitals gains when you sell investments.

However, there is no limit to how much you can invest in a brokerage account. Also, aside from taxes, there is no penalty if you withdraw the funds before the age of 59 1/2.

So, if you’ve maxed out all the tax advantage retirement accounts available to you and still have more money to invest, consider opening a brokerage account.

What’s Next?

Now that you have a basic understanding of the different types of retirement accounts, make sure you are making the most out of your investments.  

Making your own investment decisions may seem scary at first.  However, the key is a bit of upfront work to educate yourself on the basics. 

Start educating yourself today and take the investment challenge for beginners.  During the challenge you will learn how your current investments rank against the other investment options available in your portfolio. 

You will learn how to understand the true profitability of a fund.  The growth of a fund is just as important as the fees associated with it.  By the end of the challenge, you will be able to tell where your current investment funds rank against other fund options available in your portfolio.

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