Guide to financial independence part 4: retirement planning

Welcome to part four of our guide to financial freedom, where we take you through the needed steps to achieve financial independence. In our previous posts, we’ve covered some of the most common financial terms, how to deal with debt, and the different types of savings accounts. While we briefly touched on retirement savings in the last part, it’s time to dig deeper. Read on to learn about the different retirement accounts available and how they work to help you save for the future.

Why you need a retirement savings plan

According to a recent study from AARP, only a third of adults expect to be financially secure in retirement. Even more startling, results showed that this impacted Gen X most significantly and that most don’t have a plan for managing their money in retirement. But, just because you have a plan doesn’t guarantee you understand it, either—another study from AARP showed that less than half of adults 50-plus completely understand the notices they receive from their plans.

These concerns highlight the importance of having a retirement plan and understanding how your plan works to save money for your future. So, what makes a good retirement plan? In addition to building savings while you have income, your plan needs to address long-term sustainability:  how to spend money in retirement in a way that allows it to last. But what type of retirement account do you need? When talking about retirement planning, there’s a lot of letters and numbers being thrown around—you’ve likely heard the terms “401(k)” or “IRA.” Both are broad terms to describe types of retirement accounts, but there are a few differences between them and even more accounts to choose from.

What is a 401(k)?

A 401(k) is a retirement savings plan offered by your employer, where you consistently set aside a percentage of your salary to the account. One benefit is that your employer may match contributions up to a specific limit, allowing you to essentially double your contributions. 401(k)s work by investing that money, typically in mutual funds selected by the employer that are designed with a retirement year in mind. Per the IRS, the total amount contributed—from both you and your employer—in a tax year may not exceed $69,000, or $76,500 for investors 50 or older, and the total contribution cannot exceed 100% of the participant’s compensation.

There are two main types of 401(k)s—traditional and Roth. Contributions to a traditional 401(k) are made pre-tax, meaning they reduce your taxable income for that year by the contribution amount. However, this ultimately means that income tax will be paid on withdrawals. With a Roth 401(k), you contribute after-tax money. While you won’t get the upfront tax break, you do get tax- and penalty-free withdrawals in retirement, as long as you’re at least 59 ½ years old and have had the account for at least five years. There’s no penalty for withdrawals from traditional 401(k)s either, as long as the distributions are made at age 59 ½ or older.

However, if you find yourself in need, you may be able to make an early withdrawal from your 401(k). Some common examples of hardship withdrawals include tuition and related educational expenses, medical bills, and primary home purchase expenses. It’s important to note that hardship distributions may be subject to income tax and an early withdrawal penalty of 10%.

Overall, 401(k) plans can be a great option for retirement savings, especially if your employer offers a contribution match, as you can easily contribute from your paychecks. However, you may not have an employer-sponsored plan or find you want more flexibility in retirement savings. That’s where an IRA comes in.

What is an IRA?

IRA stands for an individual retirement account, a retirement savings account held by a credit union or bank, an investment company, or a brokerage firm. Primarily designed for people without access to a 401(k), anyone with earned income can open an IRA, so some people open one to have an additional source of retirement income.

Like 401(k)s, you may have a traditional or Roth IRA. With a traditional IRA, you make contributions pre-tax, allowing you to reduce your taxable income for the year. The money set aside grows tax-deferred, and you can withdraw from the account without penalty once you reach 59 ½, though you’ll have to pay taxes on it. For 2024, the maximum annual individual contribution is $7,000, and those age 50 or older can make catch-up contributions up to an additional $1,000 ($8,000 total).

If you don’t have an employer-sponsored retirement plan, your traditional IRA contributions are fully deductible. But if you—or your spouse—have a retirement plan at work, like a 401(k), your modified adjusted gross income (MAGI) determines if and how much of your contributions can be deducted. Again, like a Roth 401(k), contributions to your Roth IRA are made after tax, so you won’t pay taxes later, even on your investment gains. Contribution limits are currently the same as traditional IRAs. However, there are income limitations on contributions to a Roth IRA. For the 2024 tax year, single filers are limited to $146,000 to $161,000, while married couples filing joint returns are limited to $230,000 to $240,000.

Another difference between Roth and traditional accounts is that Roth IRAs don’t have required minimum distributions (RMDs). RMDs are a set amount of money that must be withdrawn annually from certain retirement plans like traditional 401(k)s and IRAs, and they have to be taken by April 1st after you turn 73 years old, or you risk a penalty. With a Roth IRA, you don’t have to make a withdrawal if you don’t need it, allowing your money to continue growing tax-free. Additionally, you can keep making Roth IRA contributions regardless of age as long as you have eligible earned income. As of 2024, Roth 401(k)s from 2024 or later are also now exempt from RMDs.

One of the biggest benefits of an IRA compared to a 401(k) is that you have the ability to invest your money across multiple options, like stocks, bonds, and mutual funds, as opposed to a singular investment option with your 401(k). However, contribution limits are much lower, and you won’t get matching contributions from your employer.

Other retirement accounts

There are many types of retirement accounts, but there are a few other common ones. If you’re a small business owner or self-employed, you may also have the option to set up a Simplified Employee Pension (SEP) IRA—where contributions are made directly from the employer into an account set up for each employee—or a Savings Incentive Match Plan for Employees (SIMPLE) IRA, which allows both employers and employees to contribute to a traditional IRA. If you’ve left a previous employer, you may also have a rollover IRA, which is funded by money “rolled over” from an employer-sponsored plan. Which, aside from a 401(k), could be a 403(b). A 403(b) plan is essentially the same as a 401(k), but offered by tax-exempt organizations like hospitals, schools, and nonprofit organizations.

Key takeaways:

• Start saving for retirement as soon as possible.
• IRAs are individual retirement accounts, while 401(k)s are offered by employers.
• Traditional 401(k) and IRA contributions are made before tax, and grow tax-deferred. Roth 401(k) and IRA contributions are made after tax and grow tax-free.
• IRA contribution limits for 2024 are $7,000, and those age 50 or older can make catch-up contributions up to an additional $1,000 ($8,000 total).

Planning for retirement can be overwhelming, especially with all of the options available and the different rules for each kind. We hope this helps you understand the different types of accounts and why saving for retirement now is a critical step for financial freedom later.

Still feeling stressed? Our team of financial professionals is available to help you determine your best steps for success!