Which type of retirement account is best for your situation? Learn about the various tax advantages of different types of retirement accounts here.
Even though most people don’t retire until their later years in life, it’s important to start planning for retirement as soon as you can.
There are many different ways to save up for retirement, but some are better than others. The best retirement accounts are those that are tax-advantaged.
Tax-advantaged accounts are beneficial because the IRS gives these accounts a tax break of some kind. They are either tax-deferred or tax-exempt.
We’ll explain more below:
Tax-Deferred vs. Tax Exempt
With tax-deferred retirement accounts, you pay taxes when you withdraw
money not when you contribute. But, you can deduct your contributions from your taxes during the year you make them.
These types of retirement accounts are best for high earners since they can lower the taxable income significantly.
Tax-exempt retirement accounts receive no immediate tax deductions, but you will be able to withdraw all of this money at retirement without paying taxes on it.
These accounts are best for low-income individuals with a higher expected income at retirement.
For more information on tax-deferred and tax-exempt retirement accounts, read this article from Investopedia.
5 Best Tax-Advantaged Retirement Accounts
There are many tax-advantaged retirement accounts, and they all have different requirements and features.
These five accounts below are your best bet for a comfortable retirement.
1. Employer-sponsored 401k
The most common retirement account for employed individuals is a traditional 401k sponsored by their employer.
These accounts are tax-deferred, meaning that you can deduct your contributions from your taxable income.
Most times, employers set up automatic deductions from your paycheck, and they will often will match your contributions.
Contributions limits to these accounts are set by the IRS and change each year. Find this year’s limits here.
It’s important to note that once you are over the age of 50, you can contribute more. Also, you get to keep your account even when you change employers.
If you withdraw from this account before the age of 59 and a half, you will be charged a 10% penalty for early withdrawal. But, you have to start taking distributions by age 70 and a half.
Your 401k should be the first resort when planning for retirement, and you should do your best to max out your 401k as much as possible.
Sofi gives you some pointers on how to do that here.
2. Solo 401k
A solo 401k is also tax-deferred and is basically a 401k plan for self-employed high-earners.
This account grows from self-employment income contributions but can also include profit-sharing contributions.
This means that you can add to this account from your weekly allotment that you give yourself and add from your self-paid salary.
There are limits to the amount you can contribute to this account, as well. The IRS determines these limits. Find out up-to-date contribution limits to solo 401k retirement accounts here.
3. Health Savings Account
Another tax-deferred account that doesn’t exactly count as a retirement account but can be used as such is an HSA or health savings account.
These accounts allow you to save some of your income to use later to pay for medical expenses. Of course, there are some eligibility qualifications to open one of these accounts.
An HSA is perfect for those that don’t qualify for Medicare due to their income level but still want to save for the impending medical bills that come with old age.
As expected, the IRS has to put some limitations on this type of savings account. Read this short PDF to learn about the rules of health savings accounts.
4. Traditional IRA
This tax-deferred retirement account is like a self-directed 401k plan, but the contribution limits are lower.
This is an effective route if you have already maxed out your 401k but would like to hedge your account with extra savings towards retirement.
The eligibility to open and contribute to a traditional IRA depends on your income. This is determined (you guessed it) by the IRS read about that here.
5. Roth IRA
The most popular retirement account to add to your retirement savings tax-free is a Roth IRA. There are many benefits to a Roth IRA that don’t come with a traditional IRA.
Instead of being tax-deferred, a Roth IRA is a tax-exempt account. This means that you don’t get an immediate tax break, but you don’t have to pay taxes when you make withdrawals after you retire.
A Roth IRA also gives you the option to withdraw in the case of emergencies. Before the age of 59 and a half, the original contributions can be withdrawn without any problem.
If you withdraw the investment gains, they will be taxed, and you will be penalized. After the age of 59 and a half, all withdrawals from your Roth IRA are untaxed.
Unlike a traditional IRA, which comes with a hefty penalty fee if you fail to make a required minimum distribution (RMDs) after the age of 72, you are free to keep your savings in your Roth IRA as long as you want.
Another benefit to Roth IRAs is that you can feel confident leaving these savings to your loved ones as an inheritance without strapping them with a tax penalty.
The same contribution limits apply to Roth IRAs as traditional IRAs. If you have both, your combined contributions cannot exceed the limit.
If you make too much money to be eligible for a Roth IRA, you can convert a traditional IRA into what is called a backdoor Roth IRA. You will have to pay some taxes, but the benefits are worth it.
Learn more about how to open a backdoor Roth IRA here.
Conclusion
These five types of retirement accounts are the best to utilize due to their cost-effective nature. Use these to put more of your hard-earned money towards retirement instead of handing it over to the government.
Adam Marshall is a freelance writer who specializes in all things apartment organization, real estate, and college advice. He currently works with NorthStar Georgetown to help them with their online marketing.
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