Sometimes you don’t have access to a 401(k). Sometimes you want to have more control over which funds you’re investing in. Sometimes you just want to have more retirement savings vehicles available to you. The IRA is the unheralded hero of the modern-day retirement savings plan. Find out why.
IN THIS WEEK’S EPISODE
- Understanding the basics of IRA accounts
- Detailing traditional and Roth IRAs, SIMPLE IRAs, SEP IRAs and Individual 401(k)s
- How do IRA contributions work?
- Breaking down the ins-and-outs of how IRAs work in retirement
- Mixing and matching retirement accounts
- My favorite investment firm for IRAs: Vanguard
- How Roth accounts work and why I’m a really big fan
- What happens if you need early access to your IRA funds?
Understanding Retirement Accounts: IRAs
Let’s get started by setting some definitions.
Whereas 401(k)s and other defined contribution plans are set up through your employer, Individual retirement accounts, or IRAs for short, are retirement savings vehicles set up and managed by individuals.
There are several types of IRAs: Traditional IRAs, Roth IRAs, SIMPLE IRAs and SEP IRAs.
Traditional IRAs are one of the more common types of IRAs, and function very similarly to traditional 401(k)s offered at work. Rather than being deducted from your paycheck pre-tax, traditional IRA contributions are tax deductible come tax season (depending on your adjusted gross income), which allow your contributions to grow tax-free until you retire.
If you have no retirement plan at work and you’re younger than 70.5, you can contribute $5,500 (or $6,500 if you’re older than 50) and deduct the entire amount from your taxes. If your spouse doesn’t work outside the home, they can also invest up to the federal limit and deduct the full amount.
If you do have a 401(k) or other retirement plan at work, your contribution is fully deductible only if your adjusted gross income is less than $61,000 for an individual or $98,000 for a married couple filing jointly. In this case, when you have a workplace retirement plan available, the deduction for your traditional IRA contribution is phased out completely if your AGI $71,000 or more as an individual filer or $118,000 or more for a married couple filing jointly.
If you’re not covered by a workplace plan but your spouse is, your contribution is fully deductible if your combined income is less than $184,000 and gets phased out at $194,000 or more.
You will decide in which stocks, bonds and mutual funds you invest in, and will benefit from the contributions growing tax-free (if you fall within the deduction limits previously mentioned).
In retirement, your withdrawals from you traditional IRA account(s) will be taxed as income tax, which may be at a lower tax bracket rate than you would have paid when you were in your peak working years.
Contributions are locked by the same early withdrawal penalty that traditional 401(k)s face: 10% plus income taxes on the withdrawal, so you’ll have access to the funds in an emergency, but as with 401(k) early withdrawals, it should be a last resort.
Roth IRAs are the other common IRA option, and contributions grow with after-tax dollars. More on Roth accounts later.
In addition to the more familiar traditional/Roth IRA plans available, there are three other IRA options available to you are self-employed.
SIMPLE IRAs, or Savings Incentive Match PLan for Employees, are a IRA plans available to small businesses with less than 100 employees and no other retirement savings plan in place for their employees. SIMPLE IRA plans function just like a traditional IRA, where employees enjoy tax advantages with their contributions, and are subject to the same withdrawal age of 59.5.
They are usually offered by small business employers who wish to offer an uncomplicated retirement savings plan without taking on the burden of funding the entire plan as the employer. The option to fund the account is up to the employee, but does require the employer to match employee contributions, either 100% of 3% of employee’s salary, with the option to decrease that match down to 1% in any two out of five years, or a flat 2% of employee’s salary. This plan doesn’t require you to have employees beyond yourself, so it’s an option if you’re a sole proprietor, but if you’re a sole proprietor, you might be better off focusing on a SEP IRA instead.
If you’re setting up a SIMPLE IRA, you’ll benefit from a simpler setup process and lower account management fees which can help your accounts grow faster.
With a SIMPLE IRA, employees (like you!) can contribute up to 100% of their net earnings from self-employment up to $12,500 (or $15,500 if you’re over 50), plus a match from the employer (that’s you again!) of 2-3% of your net earnings from self-employment. As you can see, a SIMPLE IRA can give you more contribution options and tax advantages than a Traditional IRA, but there’s another self-employment option that gives you more growth options, the SEP IRA.
If we look at a basic example, and you make $100,000 in net earnings from self-employment, you, as the employee, may contribute up to $12,500 plus get up to 3% from your employer (you!), which would give you SIMPLE IRA balance of $15,500 for the year.
SEP IRAs, or Simplified Employee Pension plans, are another type of IRA that are available to small businesses with at least one employee, and are usually a good option for sole proprietors, or really generous employers. That’s because the plan is entirely funded by the employer.
What’s more, with a SEP IRA, you can still contribute to another tax-advantaged retirement savings account, which can be helpful if you’re still working a “day job” where you have the opportunity to contribute to a 401(k).
With a SEP IRA, the contributions can ebb and flow depending on the business’ success, which offers some great flexibility for self-employed people who experience revenue variability. As the business owner, you may contribute up to 25% of your net earnings from self-employment up to $53,000.
By way of simple example, if you earned $100,000 in net earnings, your business could contribute up to $25,000 into your SEP IRA for the year.
It’s not technically an IRA, but since it involves individual retirement savings, we’ll cover individual 401(k)s in this episode. Individual 401(k)s are only for sole proprietors, and they are ideal if you intend to catalyze your retirement savings in a major way. An individual 401(k) allows you to save for retirement both as an employer and an employee, often enabling you to contribute more than would be possible with other retirement plans.
Here’s what I mean.
Just like a workplace 401(k), the annual employee contribution limit is $18,000, which can be all or a portion of the earned income. Additionally, the business can contribute a defined, tax deductible percentage of up to 25% of earnings into the plan as well. Your total employee+employer contributions can be up to $53,000 in any given year. So, if you earn $100,000 as a sole proprietor, you can sock away up to $43,000 per year ($18,000 + $25,000). That’s some major retirement savings!
Just like a traditional IRA, the contributions are tax deductible and the earnings grow tax-deferred, with income taxes only paid upon withdrawal in retirement.
What makes the Individual 401(k) different than SIMPLE and SEP plans is that you can set it up so that your employee contributions can be made on a Roth basis, meaning that they’re made with post-tax dollars today, but won’t be subject to any tax in retirement. I’ve teased these Roth accounts a couple times today, and we’ll get to those account types shortly.
Mixing and Matching Vehicles
In general, even if you have a retirement savings account at work through a 401(k) or similar account, you can still contribute to either a traditional, Roth, SIMPLE, SEP or Individual 401(k), but it may impact some of the contributions you make through some of these supplemental IRA options. Definitely seek professional help from your CPA to figure out the right order of operations for these accounts and contributions to make sure you’re maximizing the benefit.
For instance, as we already discussed, your traditional IRA tax benefit might be limited if you have a workplace 401(k) available, but your deduction on a traditional IRA might also be limited if you have one of these self-employment plans, because it then technically is considered a workplace retirement plan.
What’s more, you’re going to be capped at $18,000 of total employee contributions to a 401(k), regardless of whether the 401(k) is at work or through an individual 401(k). For example, if you contribute, say, $4,000 to a workplace 401(k) so that you can get an employer match, and then you also open up an individual 401(k) because you’re a sole proprietor of a side hustle, you’ll only be able to contribute $14,000 to the individual 401(k). However, you’ll still be able to contribute an employer match to that individual 401(k).
Also, one of the great features about the three self-employment options we discussed (SIMPLE, SEP or Individual 401(k)) is that you can still have a traditional or Roth IRA and a workplace 401(k).
You may not be at a point yet where you’re carving out enough savings to deploy to several different accounts, but since we’re going to be talking about supplemental income streams on this podcast, it’s good to know that you have several options available to you.
Let’s take a quick break to talk about my favorite investing site, especially when it comes to IRAs.
You may have heard about Vanguard before. They’re a pretty big name in investing, competing with the likes of Fidelity and Charles Schwab. Vanguard is very much a self-service option for investors who want to open and manage their own investment accounts. I only know of Vanguard’s traditional and Roth IRA accounts, because last year I rolled over a few different 401(k) accounts that were with previous employers. They also offer the other types of accounts that we’ve covered today: SIMPLE IRAs, SEP IRAs and traditional and Roth Individual 401(k)s.
What sets Vanguard apart is two things: 1) they don’t try to dominate the market, they’re very much focused on tracking the indices and trying to just get steady returns, and 2) they have ridiculously low expense ratios (or the percentage of your portfolio that you pay to fees), which lets you keep even more of your money. Their average expense ratio is 0.18%, compared to 1.01%. That is a VERY major difference in fees, and makes a significant impact over the course of a career and subsequent retirement.
If you’re looking to open up any of these IRA accounts, my suggestions would start and end with Vanguard. Admittedly, I haven’t looked into some of the other providers, but I’ve only heard good things about Vanguard, and after my traditional and Roth IRAs at Vanguard had really juicy returns last year compared to our workplace 401(k) options, I have no reason to consider switching.
Check them out at modestmillions.com/vanguard.
A Word About Roth
I’m really excited to talk about Roth accounts, because there are some distinct differences between traditional accounts and Roth accounts that, at least in our situation, create for very favorable situation in retirement. There are pros and cons to both traditional and Roth accounts, and next week we’ll dive into those in more detail. For now, let’s focus on the Roth accounts.
First, in case you’re curious (I was!), Roth accounts are named after Delaware Senator William Roth when he introduced the concept of post-tax retirement savings into the Taxpayer Relief Act of 1997.
In terms of differences between the two accounts, it really comes down to when you pay income tax. Traditional 401(k) and IRA contributions are made with tax-free money on the front-end, whereas Roth contributions are made with post-tax money out of your net paycheck. It means you have a little less money to invest, but both your contributions and earnings grow tax-free in retirement, not tax-deferred like traditional accounts. That means that when you withdraw the money in retirement, all of it will be tax-free. So, in theory, if for some reason you funneled all of your retirement savings into Roth accounts during your working years, you would pay zero income taxes in retirement.
As for contribution limits, it’ll depend on if it’s a Roth 401(k) or a Roth IRA. You’re permitted to contribute up to $18,000 in a Roth 401(k) but only up to $5,500. These are individual limits, so if you’re married, both you and your spouse can contribute up to these maximums. If you’re over 50, you can contribute a little more during the catchup period, so you can check out those limits if they apply to you.
Additionally, Roth IRAs are subject to income limits, so not everyone can contribute to a Roth IRA. Roth IRA contributions are limited by income level. In general, you can contribute to a Roth IRA if you have taxable income and your modified adjusted gross income is either:
- Less than $194,000 (phasing out from $184,000) if you are married filing jointly.
- Less than $132,000 (phasing out from $117,000) if you are single, head of household, or married filing separately (if you did not live with your spouse at any time during the previous year).
Need Early Access?
A nice little perk about Roth IRA contributions is if you need to access your retirement savings early, you can withdraw your contributions penalty-free (and avoid the 10% penalty that you’d pay with a traditional account). Note this is only for contributions, not your earnings.
There are special exemptions with IRA accounts that will let you withdraw money before 59.5 and without the 10% penalty on your traditional IRA or your earnings from your Roth IRA. So, if any of the following situations apply to you, you could consider withdrawing from your IRA:
- Paying college expenses for you, your spouse, your children or grandchildren.
- Paying medical expenses greater than 7.5% of your adjusted gross income if you’re age 65 or older. The threshold is 10% for those under age 65
- Paying for a first-time home purchase (up to $10,000).
- Paying for the costs of a sudden disability.
Using your IRA funds for these purposes should be considered a last-ditch option. Even though you’re not paying the 10% penalty, you’re taking that money out of the money workforce, and it’s no longer working for you to earn gains. But, like everything else, it’s good to have options in case you need them.
That’ll do it for this week’s episode.
What about you? Have you set up any IRAs, SIMPLEs, SEPs or Individual 401(k)s? Where did you open your accounts? Vanguard, Schwab, Fidelity, somewhere else? I’d love to hear from you.
Also, make sure to reach out with your feedback for me or for the show, topic ideas, personal anecdotes of your own journey or if you just want to say hi. You can always reach me at feedback[at]modestmillions[.]com.
For a recap of the strategies, tools and links that we talked about today, check out the show notes at modestmillions.com/006.
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Join me next week when we continue our series on retirement savings and talk about the pros and cons of traditional versus Roth accounts and figuring out which option(s) might be right for you and your situation.
Until then, remember to keep squirreling away now to earn millions later!
Thanks for listening; we’ll see you next time!