A Guide to Understanding Your Retirement Account Options

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A Guide to Understanding Your Retirement Account Options

These days, retirement is proving to a massive topic. Between consistent talk and speculation about the future of Social Security to the fact that we as humans tend to be living longer now, there have been many efforts to make individuals aware of how they should be preparing for retirement.

While you may know the basics — such as start early and save as much as you can — you might not be so familiar with some of the many different retirement account options or what they entail. To help give you an overview of a few popular account types, let’s take a look at some different 401(k)s and IRAs as well as what the growing trend of self-directed retirement accounts could mean for your investment choices.

401(k)s

Standard 401(k)

2018 contribution limit (under 50): $18,500
2018 contribution limit (50+): $24,500
Biggest benefit: Some employer plans include matching fund offers and profit sharing opportunities
Biggest drawback: Not all employers offer plans or employees may not qualify to join plans
Best for: Eligible employees who want to easily save for retirement — and maybe even get a little extra.

If you’ve ever had a full-time job, there’s a good chance you’ve at least heard about 401(k) plans. These ultra-popular retirement savings plans allow eligible employees to contribute a portion of their pay to retirement accounts, which may be invested in various mutual funds. Traditionally, 401(k) plans are set up by employers and eligibility for joining may depend on your length of service, full time status, or other factors.

On top of employee contributions, many employers offer some form of matching funds. For example, a company might offer to contribute 2% of an employee’s income toward their 401(k) savings if the employee also contributes 4% on their own. Furthermore, employers might issue profit sharing payouts via 401(k) contributions as well.

401(k) Vesting – What You Need to Know About Cliff and Graded Vesting

Something important to note about employer matching funds is that they may be subject to something called “vesting.” While any money you put into your 401(k) will be yours to keep regardless of when you choose to part with your employer, different companies have differing rules about how much of their contributions you’ll be entitled to.

Two often-used forms of vesting are cliff vesting and graded vesting. Cliff vesting might mean that you are only entitled to keep matching funds after you’ve been with the company for five years — meaning you’d either get 0% matching funds (years one-four) or 100% (year five or after). Meanwhile graded vesting might increase the percentage of matching funds you’re entitled to with each passing year. In this scenario, you might become 20% vested after one year, 40% vested after two years, etc.

The Perils of Early Withdrawals

Like many types of retirement accounts, you’ll be hit with a penalty if you try to withdraw funds before you turn 59 ½. With the penalty currently priced at 10% of your withdrawal, this is clearly not the best financial move. Luckily, if you’re really in need of cash, you may be able to borrow from your 401(k) using an aptly named 401(k) loan. For more details, you’ll need to speak to your plan provider, but typically the interest rates on these loans are fairly low. Just keep in mind that your loan payments will comes directly out of your paycheck according to the terms you selected.

What Happens to Your 401(k) When You Leave the Company?

Finally, when you do terminate your employment with the company sponsoring your 401(k) plan, you’ll have several choices of what to do with your savings. One option is to roll your funds over to an IRA. Alternatively you may actually be able to leave your funds in the company plan, although you will no longer be able to make contributions. While this may be the easiest plan, beware of issues such as 401(k) forceout that can occur if your balance is below a certain threshold. Additionally, if you have an outstanding loan balance at the time of your termination, the amount you owe may become a withdrawal and be subject to both taxes as well as that 10% penalty.

Solo 401(k)

2018 contribution limit (under 50): $55,000 total (up to 100% of compensation up to $18,500 plus employer nonelective contributions up to 25% of compensation)
2018 contribution limit (50+): $61,000 total (up to 100% of compensation up to $24,500 plus employer nonelective contributions up to 25% of compensation)
Biggest benefit: Far higher contribution limits than IRA
Biggest drawback: Limited to only self-employed business owners with no employees
Best for: Self-employed individuals who want the ability to set aside more of their income for retirement.
Notes: Can also be Roth.

With the number of self-employed and “gig economy” workers on the rise, many Americans may no longer have access to an employer-sponsored 401(k) plan. That’s where Solo 401(k)s — which the IRS officially refers to as One-Participant 401(k) Plans — come in. These plans offer self-employed individuals and their spouses the ability to contribute to tax-deferred retirement plans with much higher annual limits that most IRAs.

There are restrictions to who can open and contribute to a Solo 401(k). First, when they say “solo,” they pretty much mean it as only businesses consisting of one person or one person and their spouse may be eligible to open this type of account. It’s also important to know that, if you or your spouse has another 401(k) you’re contributing to via a separate employer, you must consider how much you’re deferring to each plan. Remember: contribution limits are per person, not per plan.

Another somewhat confusing element of Solo 401(k)s is understanding how the contribution limits work. The idea is that self-employed individuals act as both employee and employer. Thus individuals may contribute up to $18,500 a year (or $24,500 if you’re over 50 years old) just like other types of 401(k) plans. However, as an employer, you can also contribute up to 25% of your compensation as defined by the plan, up until the total limit of $55,000 for those under 50.

While setting up a Solo 401(k) will require some research on your part, the good news is that these plans can be very customizable. For example, you can elect to do a Roth Solo 401(k) and/or make it a self-directed account. We’ll talk more about what both of those things mean a bit later. For the record, Solo 401(k)s may also offer loan options like employer-sponsored ones do.

The bottom line is that, if you’re self-employed and want to set aside as much money as possible in a retirement account, a Solo 401(k) may be a great option.

IRAs

Traditional IRA

2018 contribution limit (under 50): $5,500
2018 contribution limit (50+): $6,500
Biggest benefit: Easy to open and contribute to
Biggest drawback: Low contribution limits
Best for: Anyone wanting to set aside more money for retirement

Depending on who you ask, IRA either stands for “Individual Retirement Account” or “Individual Retirement Arrangement” (the IRS opts for the latter). Either way, Traditional IRAs are popular retirement options for a number of reasons. Among them is the fact that they’re relatively easy to set up and start contributing to. The only downside is that, if you’re relying solely on an IRA to save for retirement, you won’t be able to set aside very much each year.

Currently the annual contribution limit for an individual under 50 is $5,500. That said, if you have a 401(k) as well, you are able to contribute up to that limit in addition to maxing out your IRA contribution limit. However, before you go thinking that you can just open multiple IRAs in order to stash more retirement money, contribution limits are per person, not per plan.

With “IRA” being a general term, there are different “styles” (if you will) of accounts you can spring for. For example, next we’ll dive into the differences between Traditional IRAs and Roth IRAs. Later, we’ll also take a closer look at self-directed IRAs and the different investment options they bring. But, for now, just know that Traditional IRA is just one of many retirement accounts you can open.

Roth IRA

2018 contribution limit (under 50): $5,500*
2018 contribution limit (50+): $6,500*
Biggest benefit: Funds — including any earnings — can be withdrawn tax-free as long as you’re beyond the requirement retirement age.
Biggest drawback: Contributions are not tax deductible and high-income earners are excluded
Best for: Young savers who are currently in a lower tax bracket and can afford to forgo the current year tax deductions
*Note: Contribution limits may be reduced based on your Modified Annual Gross Income (AGI).

When you get down to it, Roth IRAs and Traditional IRAs are very similar… except completely different. While they both maintain the same contribution limits and many other aspects, the big difference between the two lies in the tax benefits. With a Traditional IRA, you’ll be able to deduct your contributions from your taxable income but will then pay taxes when you withdraw funds come retirement. Meanwhile, with a Roth IRA, you will waive any immediate tax deductions (meaning you’ll end up paying taxes on your contributions) but will then be able to make tax-free withdrawals once you reach retirement age. This even includes any gains you account has made, making Roth IRAs a real deal for many savers.

Unfortunately, there a couple of catches when it comes to Roth IRAs. The first is that there are limits on how much you can make and still contribute to a Roth account. Therefore high income earners (those making more than $199,000 if married and filing jointly, for example) will have to look elsewhere.

Here’s a look at how the current income limits break down (from IRS.gov):

If your filing status is And your modified AGI is Then you can contribute
Married filing jointly or qualifying widow(er) <$189,000 Up to the limit
>$189,000 but <$199,000 A reduced amount
>$199,000 zero
Single, head of household, or married filing separately and you did not live with your spouse at any time during the year <$120,000 Up to limit
>$120,000 but <$135,000 A reduced amount
>$135,000 Zero

While the goal of retirement savings should be to build up as much as possible and not touch your funds until you actually retire, another benefit of Roth IRAs is that you may be able to withdraw your money without penalty — but keep reading. There are several rules that dictate whether or not you’ll incur a penalty. So, if you’re thinking about using a Roth IRA as a slush fund instead of a real retirement account, I suggest you think again.

SEP IRA

2018 contribution limit (under 50): Lesser of 25% of compensation or $55,000
2018 contribution limit (50+): Lesser of 25% of compensation or $55,000
Biggest benefit: Gives business owners a simpler way to contribute to retirement savings of themselves and their employees
Biggest drawback: Contribution limits may be lesser than other options.
Best for: Small business owners or self-employed individuals who don’t want to set up a Solo 401(k)

First, let’s answer the question I’m sure you’re wondering: what does “SEP” stand for? The answer is Simplified Employee Pension — which should give you a better clue about what the function of these accounts is all about. Think of this as a way to offer a retirement benefit to your small business employees without having to set up a 401(k) plan. Of course you can also utilize a SEP IRA as a self-employed individual.

On the surface, SEP IRAs may appear fairly similar to a Solo 401(k). After all, at $55,000, they seem to have the same overall contribution limit. However, in this case, it’s what comes before that number that makes the real difference.

SEP IRAs allow you to contribute up to 25% of your compensation, not to exceed $55,000. This means that, if you make $100,000 a year, you could contribute as much as $25,000. Meanwhile, with a Solo 401(k), you’d be able to contribute $18,500 as an employee and another $25,000 as an employer, for a total of $43,500 — or $49,500 if you’re 50+.

The other major difference between a SEP IRA and a Solo 401(k) is who is eligible to start one. Whereas Solo 401(k)s are only for business owners with no employees (save a spouse), SEP IRAs are intended for business owners with one or more employees. And in contrast to traditional 401(k)s, employees under a SEP IRA cannot make contributions of their own. Instead SEP IRA employers will make contributions to all eligible employees.

Last but not least, while Solo 401(k)s can be Roth, SEP IRAs follow the Traditional structure. For all of these reasons, self-employed business owners with no employs may prefer a Solo 401(k) while business owners who want to help their employees save for retirement may elect to set up a SEP IRA.

Self-Directed Accounts

Biggest benefit: You’ll be able to invest your money in a number of different ways — not just in stocks and bonds.
Biggest drawback: Depending on your investments, this can be risky
Best for: Those who want to invest in alternative ways while still saving for retirement and enjoying the tax benefits of such accounts.

When most people think about retirement accounts, they likely presume that they’re all invested in your standard mix of stocks and bonds. That may have been the case once upon a time but, today, self-directed retirement accounts are giving individuals greater choices for where they invest their money. From real estate to peer to peer lending or even businesses, these types of accounts bring you a whole world of options.

The four main forms of self-directed retirement accounts are self-directed IRAs, self-directed Roth IRAs, self-directed traditional Solo 401(k)s, and (as you may have guessed) self-directed Roth Solo 401(k)s. Despite the “self” tag in each of these options, your account will actually need to be held by a trustee or custodian. There are now several different self-directed account custodial companies available, so be sure to shop around.

Speaking of shopping around, an important note regarding custodians is that they may have complicated fee structures that can eat into your savings and growth. Because of this you’ll want to pay close attention to a company’s rules when opening your account. After you’ve chosen a company, you can either start from scratch or rollover funds you might have in another retirement account.

Lastly, since self-directed accounts are more likely to be invested in “riskier” ways, consider if it makes sense to select a Roth option. That way, if your investment does pay off big time, you can withdraw those gains tax-free once you retire. Of course it’s always a good idea to talk to a tax professional and/or fiduciary when selecting your retirement options.

Things you can invest in with a self-directed retirement account

Real estate

You’ve probably heard about many wealthy individuals who made the lion’s share of their money by investing in real estate. That’s likely why the idea of being able to invest your retirement account savings in such a way is something that appeals to so many. As a result, you can find many articles on how to invest in real estate with self-directed accounts.

Investing your retirement account in real estate does come with a few important limitations. For one, you cannot invest in personal properties. Therefore you won’t be able to purchase a condo for your kids or snag that timeshare on the coast using your IRA or 401(k). This is just one of several rules that can come into play, so be sure to read up on all of the limitation and quirks before landing yourself in trouble with the IRS.

Peer to peer lending

Another investment opportunity that’s made headlines in recent years is peer to peer (P2P) lending. If you’re not familiar, P2P companies like Lending Club allow investors to fulfill loan requests from approved borrowers. In return, lenders receive a cut of the interest that borrowers end up paying over the life of the loan. While you could just invest your funds in the “traditional” way, Lending Club and others have allowed for self-directed account holders to place their funds into the platforms as well. Thus, this could be another alternative investment you might consider trying.

Businesses

Put simply, yes, you can use your self-directed retirement account funds to invest in businesses. But, with the IRS being involved here, there’s really no “simple” answer. Like with real estate, there are restrictions on how much you can directly benefit from an investment along with plenty of other rules. So, once again, it’s best to speak with a professional about your plans before pursuing this path.

Cryptocurrencies

According to The Motley Fool, there are actually some reputable custodians that will allow you to invest your retirement accounts in cryptocurrencies. Is this a good idea? Probably not — at least not at the moment. Still, I include this just to show how far-reaching self-directed IRAs and 401(k)s can be.

Things you can’t invest in with a self-directed retirement account

On their website, the IRS notes that you are not able to invest self-directed retirement funds in life insurance or various collectibles. What qualifies as a collectible? Here’s their list:

  • Artwork
  • Rugs
  • Antiques
  • Metals – with exceptions for certain kinds of bullion
  • Gems
  • Stamps
  • Coins – (but there are exceptions for certain coins)
  • Alcoholic beverages
  • Certain other tangible personal property

Keep in mind, this just a partial list of examples, so you’ll want to double check if your “investment opportunity” qualifies.


With all of this talk about things like how “70 is the new 50,” the thought of retirement may be further from people’s minds than in past decades. However, the reality is saving for retirement is now more important than ever as your funds will likely need to last longer as our average lifespan gets extended. Luckily, there are now plenty of retirement account options to fit your individual needs. From 401(k)s to IRAs, from traditional accounts to Roths, and from good ol’ stocks and bonds to alternative investments, it’s all up to you how to best save for your retirement — the most important thing is that you get started as soon as possible!

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Author

Jonathan Dyer

I'm a small town guy living in Los Angeles looking to make solid financial decisions. I write for a number of finance websites, including HuffingtonPost and Business2Community. I founded DyerNews.com in 2015 to focus on personal finance and the emerging FinTech markets.

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