When you’re saving for retirement, a tax-advantaged retirement account can do wonders for your investment growth. Here are two options.
Option 1: Your company’s 401(k) plan.
If your employer offers a 401(k) plan, take advantage of it.
Some companies will give you extra money as an incentive to save for retirement: they’ll match your contribution to your 401(k), up to a certain percentage. This money is a windfall, and you’ll need as much as you can get.
Figure out what the maximum match is, and bring your 401(k) contributions up to at least that point. Also check the vesting schedule, to determine when you’re entitled to receive the full match.
When you enroll in your 401(k), a percentage of your gross salary is diverted to your retirement account, before your income is taxed. Because only the remaining amount of your salary will be subject to income taxes, you’ll pay less in taxes for the year.
You’ll pay income taxes on your 401(k) funds only when you make distributions from your account in retirement. And if you’re spending less than you did in your working years, where presumably you will be in a lower tax bracket, you will be charged less in taxes.
You pay taxes on your 401(k) earnings only when you take a distribution. Your total untaxed earnings can continue compounding as the years go by, earning you more money than a regular taxed account.
Option 2: Open a Roth IRA.
If a 401(K) isn’t available to you, and your modified adjusted gross income is less than $107,000 ($169,000 for joint filers), your best option is a Roth IRA.
You can withdraw your contributions without penalties.
Unlike other retirement accounts, there are no penalties for withdrawing the contributions you make to a Roth IRA. Only earnings are subject to taxes and penalties.
Say you contribute $3,000 to a new Roth IRA when you’re 40 years old, and those funds earn 5 percent, or $150 by the end of the year. If you need it the following year, you can withdraw $3,000 you put in without penalty. It’s the additional $150 in earnings, if withdrawn, that could be taxed and penalized as an early distribution.
On the other hand, if you make any early distributions from a traditional IRA or a 401(K), you’ll be hit with both income taxes and a 10-percent penalty.
It’s not a good idea to remove any funds from your retirement account. But if you experience a dire emergency, you’ll know the option is there.
You can earn interest tax-free.
If you follow a few rules, your earnings in your Roth IRA can grow and be distributed to you tax-free. This is pretty amazing, especially when you compare it to the alternative: paying taxes every year on investment income you earn in a regular account. The more money you hold onto, the more interest you can earn, and the quicker your investments grow.
For tax-free earnings, you’ll need to hold the account for five years, and you can only take earnings distributions after you’ve reached age 59. There are some exceptions to the age rule, but you shouldn’t take the money out before you’re in your 60’s: it’s meant for retirement, and you’ll earn much more if you wait.
Michael Camacho is the president and chief executive officer of Personal Finance Center. He has more than 18 years experience in retail banking and with financial institutions in Guam and Hawaii.