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What is a 401k & When Should I Start?

What is a 401k & When Should I Start?

It is never too late to start saving money you will use in retirement.

However, the older you get, the more constraints like, wanting to retire, or required minimum distributions (RMDs), will limit your options. The good news is, many people have much more time than they think. Even starting at age 35 means you can have more than 30 years to save, and you can still greatly benefit from the compounding effects of investing in tax-sheltered retirement vehicles.

Key Facts

  • Even starting at age 35 means you have 30 years to save for retirement, which will have a substantial compounding effect, particularly in tax-sheltered retirement vehicles.
  • There are several important options to consider when investing specifically for retirement. 401(k)s and traditional individual retirement accounts (IRAs) are often the most popular choice.
  • Roth IRAs, tax-advantaged products like municipals, annuities, and real estate can be other good retirement investment options.

The Leading Tax-Deferred Vehicles

401(k)s and traditional individual retirement accounts (IRAs) are the leading tax-deferred vehicles for investors looking to save specifically for retirement. This is because both options allow the investor to deduct their contributions annually. Also, these vehicles allow the investor to defer their tax payments to the years they are in retirement, which is usually lower than their higher-earning years.

401(k)s

401(k)s are a top option for full-time employees who have the ability to contribute to one. Employers typically match the employee’s contributions for an added compensation benefit. Self-employed individuals and small businesses can also offer an iteration of the 401(k) with the same benefits. With this type of investing, funds are deducted pre-tax, though self-employed workers may have to make their own special deductions.

In 2020, elective deferral investing from the employee maxes out at $19,500 for the 401(k). Individuals 50 or over can add an additional $6,500. The employer and employee combined cannot exceed a contribution of $57,000 ($63,500 for 50 or older). The catch-up contribution can be especially helpful for those nearing retirement who are worried about their retirement funding.

Fast Fact

This retirement income calculator from Vanguard can help you create a retirement investing schedule based on your needs.

Any early withdrawals from a 401(k) will be charged a 10% penalty. Also, keep in mind that 401(k)s are subject to required minimum distributions (RMDs) beginning at age 72. Not taking RMDs will lead to a hefty penalty.

The Traditional IRA

The traditional IRA offers the same advantages as the 401(k). Typically, investors will invest with this vehicle on their own, many after they have maxed out their 401k contribution. For individuals, the IRA contribution limit is $6,000 in 2020 with a $1,000 catch up contribution. The IRS will impose a 10% penalty on any withdrawals taken from a traditional IRA before age 59½. For the traditional IRA, this is a flat rate penalty with no exceptions for contributions.

Alternative Options

Roth IRAs, tax-advantaged products like municipal bonds, annuities, and real estate can be other good retirement investing options to complement the vehicles above or invest in alone.

Roth IRA

Roth IRA also allows you to save and invest money for retirement while any investment earnings, gains, and interest grow tax-free. This is primarily because funds are invested with after-tax dollars. This means there is no tax deduction associated with Roth IRA contributions. This also means funds withdrawn are never taxed.

Besides the tax-free withdrawals, a big advantage for the Roth IRA is its liquidity. With the Roth IRA, all contributions and capital gains can be withdrawn both tax- and penalty-free after five years. For many investors, this is important because, after five years, the Roth IRA can also potentially serve as an emergency fund.

In 2020, you may contribute up to $6,000 to either a traditional or Roth IRA. The $6,000 limit applies to all IRAs, so you may split the $6,000 any way you would like. For those over the age of 50, the catch-up contribution applies at $1,000.

IMPORTANT: The traditional IRA has deduction limits for those with an employer-sponsored retirement plan which starts at $65,000 for single or head of household and $104,000 for joint return filers.

For the Roth IRA, you can withdraw your contributions at any time, tax- and penalty-free. The IRS does impose the 10% penalty on early withdrawals, but this is only on any earnings and not contributions.

Tax-Advantaged Products

There are a few tax-advantaged products in the market that offer some of the special benefits built into retirement vehicles. Municipal bonds, for example, can be a good, low-risk investment. Capital gains on these bonds are tax-exempt by the federal government and could be tax-exempt if the investment corresponds with the investor’s state of residence.

Annuities

Annuities can also be a good means of saving for retirement. Depending on the kind of annuity, investors may receive a specified level of return with scheduled payouts on a regular basis beginning at their desired time of retirement.

As a result of the SECURE Act passed by the U.S. Congress in 2019, annuities have become more portable, meaning they can be moved from one qualified retirement plan, such as a 401(k), to another.

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