Updated: Feb 15, 2021
Disclaimer: Although my degree is in Financial Planning, I am not a financial advisor, accountant, attorney, or tax advisor. These blogs are for informational use and all advice is based on my personal research, my experiences, and my opinions. You have to do your own research and I do not take responsibility for any losses that come with my advice. Everyone has unique circumstances and consulting a professional is always the best option.
*If you haven't already, read my first blog about the 3 things to start with before reading this one.
At some point we’ll all have to retire, but it can only happen and be enjoyed with the right amount of savings. Many people want to travel when they are retired and healthcare costs usually increase as we get older, which will all have to be covered by your retirement savings. As much as I would love to not think about me being 60 years old, it’s a reality and I need to take advantage of the time I have now so that I can retire on time or early in the future. So if you’re young and reading this, this is the best time to start saving since your money has a longer time to grow and you have less responsibilities, expenses, etc. This blog will help guide you on the basics of retirement accounts.
In basic terms, retirement accounts are a place to invest your money for the future, but they do have parameters.
There is an age limit on when you can withdraw the money contributed, if you withdraw before the allowable age, you can be taxed heavily.
There is a limit on how much money you can put into the account each year.
The accounts have some extra tax benefits that aren't offered with other accounts.
Most people are already contributing to a retirement account like a 401K or IRA. It is extremely important that if your employer has “a match” on your retirement account, you are contributing the highest amount that they will match. An employer match means that your employer is willing to put money into your retirement account for you if you contribute it, why not take advantage of this? It’s extra money for you!
For example, Company A will match 100% of Keturah’s contributions up to 3% of her income. Let’s say Keturah’s annual income is $100,000.
Scenario 1: KO contributes $3000 (3% of her income), Company A WILL ALSO contribute $3000.
Result: $6000 in her retirement account (3k + 3k)
Scenario 2: KO only contributes $1000, Company A will only contribute $1000, so KO missed out on an extra $2000 from Company A because she only contributed 1% of her income.
Result: $2000 in KO’s retirement account (1k + 1k)
Scenario 3: KO goes above and beyond and contributes $6,000 to her 401K. That’s great but Company A will still only contribute $3000 because they agreed to match up to 3% of her income in contributions.
Result: $9000 in KO’s retirement account (6k +3k)
If you are not sure how much your employer matches, locate your 401K plan which may have originally been sent through your email or contact your Human Resources department to get access to your 401K plan.
Self-Employed or Employer Does Not Offer Retirement Accounts?
If you are self-employed or your employer doesn’t offer access to a 401K plan or other retirement accounts, you can still set up a separate retirement account for yourself. As long as you have earned income, you can contribute to an Individual Retirement Account (IRA). The 2021 yearly contribution limit is $6,000 if you’re under the age of 50, but if you earned less than this $6,000 limit you can only contribute what you have earned.
For example, KO is 24 years old and earned $3,000 working at the grocery store. KO can only contribute $3,000 to her IRA, rather than the entire $6,000 limit because she did not earn $6,000.
IRA’s can be opened up anywhere; I opened mine on Betterment and they manage the investments of my contributions for a small fee. Some of the other places to open up your account will require you to choose the investments yourself, so if you are not interested in that try to find a platform that will manage the investments for you at a low cost. Even if you have a 401K with your employer, you still have the option to open up an IRA to contribute extra money to retirement if you want.
For self-employed individuals, an IRA may not allow you to contribute as much as you would like each year, so you can open a Solo 401k, Simple IRA, or a SEP IRA. These accounts allow you to contribute higher amounts and have different requirements depending on how many employees you have. If you’re considering any of these for yourself, here is a website that explains these options clearly. Since I am self-employed, I decided to open a SEP IRA on Betterment.
💲Pro Tip: When it comes to retirement, do it young and do it consistently. Don’t wait until you’re 35 to start saving for retirement, your young age helps your investments grow even more! Time is the one thing you have that others don’t and can’t make up for. Look at the scenario below of 3 people who invested the exact same amounts, but the youngest person was able to accumulate over $700,000 more than the others because he started saving early.
Can I withdraw the money that I deposit into my retirement accounts before retirement age?
You should never open a retirement account with a plan to withdraw or borrow from it before retirement age. This should be your last option in an emergency.
You CAN withdraw money from your 401K but you will have to pay a penalty fee and taxes on the withdrawal unless it qualifies as a "hardship" withdrawal. Hardship withdrawals include reasons such as economic hardship, higher education expenses, first time home purchases, or medical expenses. Although you won't have to pay the typical penalty fee for your hardship withdrawal, you will still have to pay taxes on the amount you take out. This applies to Traditional IRA's (explained below) too. You CAN also take a loan from your 401K if you must, but be sure to pay it back on time.
You CAN withdraw money from your Roth IRA (explained below) without any penalties or taxes, BUT ONLY THE AMOUNT YOU CONTRIBUTED. You will have to pay a penalty fee and taxes if you withdraw the earnings made from investing your contributions. Once you have had the Roth IRA account for 5 years, you can withdraw your money without any penalties or taxes. Hardship withdrawals are also allowed with Roth IRA's.
Roth IRA Example: In 2020, Amara contributed $3,000 to her Roth retirement account. Two years later (2022) she realizes that she will need $3,500 for a down payment on her car. She logs into her online Roth IRA account and sees that the $3,000 has increased to $4,000 with her investment choices. Although she has the entire $3,500 available for her car purchase, $500 of that withdrawal will have a penalty fee and be taxed. She can only withdraw $3,000 (what she contributed) without penalty and taxes. She decides to only withdraw $3,000 so there will be no taxes or fees on the amount she takes out.
My recommendations: Amara definitely shouldn't be withdrawing from her retirement for a car purchase, but at least she only withdrew her contributions rather than paying extra fees and taxes for withdrawing earnings. This has hurt Amara's long-term retirement goals, but hopefully she will continue to put more money into the account without withdrawals.
I want to know more about taxable benefits
The last thing I'll go over can be confusing so if you feel like you have taken in enough information for now, skip this section and come back at a later date. When people are talking about retirement accounts, you may hear the words "Traditional" or "Roth". These words describe when your retirement accounts will be taxed.
"Traditional" retirement accounts allow you to get a tax deduction NOW on what you contribute, but when you with withdraw the money at the age 59.5, you will have to pay taxes on it. People will say this option is better if you have a high income right now because you can save money on taxes today.
"Roth" retirement accounts require you to pay taxes right now on the money (like you already do), but after 59.5 you can withdraw the money and all your earnings on your money without paying taxes. People will say this option is better if you have a lower income right now because you will pay taxes on your low income, but not later when your income may be higher.
So what should I do?
After all the calculations are done, you actually may pay a pretty similar amount of taxes with either of the accounts. As always, everyone's situation is unique and what would be best for you depends. If I had to say a general rule of thumb, I would recommend Traditional IRA/401K's to high earners and to everyone else I would recommend a Roth IRA/401K because there's more flexibility with withdrawing the money you contributed. If you're still unsure, you can split your money 50/50 between Roth and Traditional accounts so you can get the best of both worlds.
🥴This is a lot of information to take in all at once, but you can always come back and read this blog multiple times if you need to. Feel free to comment any questions you have or something new you learned and try to take as many action steps as you can. Learning is the first step, taking action is the second :)
Retirement will be expensive so start saving now to plan for the future.
Make sure you are contributing as much as your employer matches if you have a 401K (Search for your 401K plan or call your HR Dept. to find out your employer match information)
If your employer does not offer a retirement account, open an IRA for yourself.
If you are self employed, research the pros/cons of a Simple IRA, SOLO 401K, or SEP IRA and choose the one that fits you best so you can start saving even more for retirement.
Here is a retirement calculator if you want to play around with how much you would need to save today to have enough for the future.
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