Retirement accountsÂ
There are several types of retirement accounts: Pensions, Traditional individual retirement accounts, Roth individual retirement accounts, 401k accounts, Self-employment accounts or simple accounts or simplified employee pension, 457b accounts.
Pension:
Used mainly by government agencies but in the past more private companies were offering them. The fund is paid into by the company and the employee. Employees have a certain amount that they pay and depending on how long they work will be paid a certain amount after they retire. The company is responsible for paying and has to manage the fund. They can be dependent on earnings the fund has or guaranteed by the company. You will be taxed when receiving the money in retirement. These are more costly to maintain and why most companies don’t have them. You will probably have the choice of lump sum or payments. You don’t necessarily have to be at retirement age to start getting payments. How you take the payment will be dependent on your situation. The company could go bankrupt leaving you nothing. You can roll this into an IRA. Some people also start fixed annuities to have a payment income.
If you are in good health and expect to live much longer it may be better to take the payments for life if the math works. If you are unsure it might be better to take the lump sum.
Example:
A 70 year old female has been working for 40 years in the same government position. Expecting to live until about 90 years old.
Lump sum is 800k. If taken then have to pay taxes of 160k. Amount is now 640k. Invests the cash making 20% per year living on investment. That is 128k per year. This will also be taxed.
Monthly payments are 4k per month with cost of living adjustment of 3%. You would have 49k per year that would be increasing by 3% per year. You will be taxed. It would take 20 years to cross over the lump sum amount without investing (800k). She would be at age 90.
Seems to be best to take the lump sum and place it in an IRA with some investments.
Traditional IRA and Roth IRA:
Individual retirement accounts are offered by companies and you may start your own. They have contribution limits per year based on age. Older individuals can make catch up contributions. You will have to take distributions eventually based on age.
Roth is after taxation. Traditional is pre-tax. You can roll over other accounts into these such as the pension or other IRAs. You can roll in 401ks. Freedom to invest however you would like. You can check the limits online as they change yearly. You can make one for your spouse even if not working. If taking the money out before retirement you will have a 10% tax fee. Keep in mind that tax law changes. One other neat feature is the ability to do options. Please see the option article if you want to learn more about that.
Example:
40 year old female earning 80k per year. Single, not married. IRS tax rate at 22% for single 40k to 80k.
Traditional IRA:
You are assuming that your income will never be higher than it is currently. You are reducing your taxation. Contributing 6k per year and earning interest of 20% for 10 years. You would have 193k. This did not put you in a lower tax bracket by itself but may with other credits and deductions. At age 71 required distribution per year is $7283.
If you did well and now are in a lower tax bracket 12% making 9k to 40k per year. Then you pay $874 in tax per year on this distribution.
If you increased the tax bracket to 24% making 85k to 163k per year then you pay $1748 in tax per year.
Roth:
You are assuming that your income will grow and you will be taxed more. You are limiting future taxation. Contributing 6k per year and earning interest of 20% for 10 years. You would have 193k. At age 71 required distribution per year is $7283.
You were already taxed so you get to keep all of the $7283.
Simple accounts vs Simplified Employee Pension:
Simple accounts have more limitations than the simplified employee pension plan. They both have contribution limits. The limit of the simple plan is lower than the simplified employee pension but higher than the IRAs.You can check the limits online as they change yearly. If you own your own business or are a contractor you should have a simplified employee pension. You pay taxes before putting money in. One other neat feature is the ability to do options. Please see the option article if you want to learn more about that.
Example:
40 year old female working as an independent contractor for 10 years. Making 80k per year.
Simple:
Contributing max of $13500 per year. Without including interest over 10 years is 135k.
SEP:
Can contribute 25% or 58k whichever is less. 20k is 25% of the 80k earned. That is 200k in 10 years.
SEP is better unless the income is lower (54k or less income).
401k:
These are much more popular now than pensions. 401k have contribution limits with ability to make catch up contributions if you are older. They can transfer into IRAs and other 401ks. Similar to IRAs they can be traditional (pre-tax) or Roth (post-tax). The company can require vesting or an amount of time for you to get any money they contribute. Take advantage of employer matching. The employer does not own the money or the fund at the end. You can do what you want with it. Tax penalty for early distributions.
Example:
40 year old female earning 80k per year. Single, not married. IRS tax rate at 22% for single 40k to 80k.
Traditional 401k:
You are assuming that your income will never be higher than it is currently. You are reducing your taxation. Contributing 19k per year and earning interest of 20% for 10 years. You would have 610k. This did not put you in a lower tax bracket by itself but may with other credits and deductions. At age 71 required distribution per year is $23k.
If you did well and now are in a lower tax bracket 12% making 9k to 40k per year. Then you pay $2760 in tax per year on this distribution.
If you increased the tax bracket to 24% making 85k to 163k per year then you pay $5520 in tax per year.
Roth 401k:
You are assuming that your income will grow and you will be taxed more. You are limiting future taxation. Contributing 19k per year and earning interest of 20% for 10 years. You would have 610k. At age 71 required distribution per year is 23k.
You were already taxed so you get to keep all of the 23k.
The 457b accounts:
They can be government based or company based. This is pre-tax money. It is also called a deferred compensation plan. You reduce your taxation now and get taxed less. You would then take disbursements when you retire. This account does not have an age limit or penalty for early distributions. You can retire early and start using this. It has the same contribution limit as a 401k per year. What is strange about it is that you are not the owner of the money. The employer is. If the employer goes bankrupt this is at risk even with it being your cash. You can only move the money if you stop working there or move it to another 457b. If you are taking it out you may have the choice of lump sum or payments. The payment route will save you taxation. Usually it is payments over 10 years. Government issued plans probably are less risky.
Example:
40 year old female earning 80k per year. Single, not married. IRS tax rate at 22% for single 40k to 80k. Able to save 19k each year for 10 years earning 20%. You would have 610k. If you leave that job then you need to roll it into another 457b at the new job or take out the money. If the company goes bankrupt you lose 610k.
Putting it all together it would be this:
40 year old female earning 70k per year. Single, not married. IRS tax rate at 22% for single 40k to 80k. Does contract work self employment on the side for 10k per year. Could potentially be in a lower tax bracket if getting credits and writing off business expenses along with saving in these accounts.
Pension: her company does not have
Roth IRA: saves 6k per year
SEP IRA: saves $2500 which is 25% of 10k
401k Roth: 19k per year
457b: 19k per year
Works until age 70 and retires. With compound interest of 20% on each account she would have: 7 million in Roth IRA, 2.9 million in SEP IRA, 22.4 million in Roth 401k, 22.4 million in 457b.
With a more conservative 10% yield. 987k in Roth IRA, 410k in SEP, 3.1 million in Roth 401k, 3.1 million in 457b.
Other topics that might be of interest include HSA and a 529 college fund. Please see those articles.
If you found this helpful please view my other posts. Options and trading can also be done in these accounts tax free!