For the past few posts, we’ve been discussing 401(k) contributions, but what exactly is a 401(k)?
A 401(k) is an employer-provided retirement contribution plan with some pretty sweet tax benefits. For those of you who are making more money right now than you expect to make during retirement, a 401(k) is a great investment account. These accounts are tax-deductible and tax-deferred. That means that you make contributions from your pre-tax income, reducing the amount you are required to pay tax on during the contribution year. Then, your money grows until retirement without additional taxes being taken out and only when you finally withdraw your money are you required to pay taxes. And, as an added bonus, most employers will match 50-100% of their employees’ contributions up to a given limit, so you are basically getting a raise just by planning for your future.
But what if your employer doesn’t offer a 401(k) or you are self-employed?
Here are some alternatives that are common for various employer types:
- 403(b) - public education organizations, non-profit employers
- 457(b) - government employers
These plans all share the same basic structure and are all named after the section of tax code where they are defined. For self-employed individuals, there is also a Solo 401(k). This is a contribution plan specifically designed for small business owners with no full-time employees other than themselves and possibly a spouse.
Contribution Limits
All of the above plans have similar contribution limits and age restrictions (as of 2018):
- $18,500 annual limit for employee contributions
- $55,000 annual limit for total contributions ($61,000 for those 50 and older)
- Distributions allowed after age 59 1/2
- Distributions required after age 70 1/2
- 10% penalty for early withdrawals
Individual Retirement Accounts
In addition to employer-provided contribution plans, there are a group of individual retirement accounts (IRAs) that offer the same tax benefits.
A Traditional IRA allows an individual to contribute $5,500 per year ($6,500 if age 50+) and grow this money tax-deferred until retirement age. If your employer does not offer a retirement option, this entire contribution amount is also tax-deductible. If your employer does offer a retirement plan, you can still make tax-deductible contributions if your modified adjusted gross income is below the IRS limits.
For self-employed individuals, there is also a SEP IRA, or self-employed pension IRA. This type of account is similar to a solo 401(k), but can be used by small business owners who employee other individuals as long as you give each of your employees the same employer match that you contribute for yourself. A SEP IRA has the same contrubtion limit and distribution rules as a Solo 401(k), and can actually be used as an additional retirement account if you have both regular employment income and self-employed income. The Financial Samurai has a great article on using both to save more than $100,000 per year pre-tax.
Have you setup your retirement accounts yet? What’s holding you back?