In this post:

• What Are Tax-Advantaged Retirement Accounts?
• General Categories
• Key Features
• Types of Tax-Advantaged Retirement Accounts
  1. Traditional IRA
  2. Roth IRA
  3. SEP IRA
  4. Spousal IRA
  5. SIMPLE IRA
  6. Self-Directed IRA
  7. Non-Deductible IRA
  8. Traditional 401(k)
  9. Roth 401(k)
  10. Solo 401(k)
  11. SIMPLE 401(k)
  12. Safe Harbor 401(k)
  13. Profit Sharing Plan
  14. 403(b)

This review should not be a basis for choosing a retirement account: that would take much more study. It’s a starting point that will help you get familiar with some of the most popular options

What Are Tax-Advantaged Retirement Accounts?

Tax-advantaged retirement accounts allow you to contribute a portion of your income to a retirement fund on a regular basis. You can then invest these funds to grow your retirement savings.

The term tax-advantaged does not mean that the money you contribute is not taxed. You will pay tax on your retirement income either when the funds are disbursed or when you make the contributions, depending on the type of account you have. Your investment gains over the life of the account are usually not taxed, as long as you use them after you retire. There are different types of rules and tax advantages attached to different types of accounts.

General Categories

There are many types of retirement accounts, but there are a few distinctions to understand before we start looking at specific types.

• 401(k) plans are usually offered through an employer. The employer selects the plan provider and sets the plan terms. Many employers match a portion of your contribution, which can be a significant benefit.
• Individual Retirement Accounts or IRAs are set up by the individual holding the account. You select the provider, which gives you more options.

There are also two general types of tax benefits.

• Traditional accounts allow you to deduct your contributions from your taxable income in the year you make them. You then pay taxes on the disbursements you receive in retirement. The money in these accounts has not yet been taxed, so the IRS has strict rules on how you can use it.
• Roth accounts allow you to pay tax on your contributions in the year that you make them. Your disbursements in retirement are tax-free. The money in a Roth account has already been taxed, so the rules on how you use it are generally less strict.

Read all about the differences between Roth and traditional retirement accounts.

Each type of account has several variants, each with its own rules.

Key Features

Here are some features to look for while you assess different accounts.

• Eligibility. Some types of accounts are only available to people in certain categories.
• Income limits. People with incomes above a certain limit cannot contribute to some kinds of accounts.
• Contribution limits. There are usually limits to what you can contribute in one tax year.
• Withdrawal rules. Many accounts impose substantial penalties on withdrawals before you reach retirement age. There may be some exemptions to these rules, and you may be able to borrow from your account.
• Disbursement rules. You may be required to take disbursements from your account starting at a certain age.

The rules governing these accounts are detailed and extensive. We’ll give you a quick review, but you’ll need to do some serious research before making a final selection. If you’re not sure, consider consulting a professional advisor.

The earlier you start saving for retirement, the more you can take advantage of these accounts’ earning potential. To maximize profits, start contributing as soon as you can.

Types of Tax-Advantaged Retirement Accounts

1. Traditional IRA

A traditional IRA (individual retirement account) is a tax-deferred retirement plan. The government won’t tax your contributions. You can deduct them from your taxable income in the year you make the contributions.

Once you retire, your disbursements from the account will be taxed as regular income. 

Best for

• When you think your tax bracket will be lower in retirement.
• When contributing to it will put you in a lower tax bracket now.
• People who want flexibility. You can select your plan provider, and there’s a wide range of options and terms to choose from.

Disadvantages

• There are steep penalties for withdrawing money early.
• You must take Required Minimum Distributions starting at age 70 1/2.
• Limited annual contributions.

2. Roth IRA

A Roth IRA takes the opposite approach to taxes. You will pay tax on your contributions in the year you make them, but you can withdraw your funds tax-free after retirement. This makes them ideal for saving while you’re in a relatively low tax bracket.

Best for

• When you think your tax bracket will be higher in retirement.
• When you may need to make early withdrawals. Roth IRA’s allow tax-free, penalty-free withdrawals of your contributions. 
• Reserve funds for late in retirement: Roth IRAs have no Required Minimum Distributions.
• Young savers in relatively low tax brackets.

Disadvantages

• If your income is high you may not be eligible.
• Penalty-free withdrawals tempt you to spend your retirement funds
• Limited annual contributions.

3. SEP IRA

SEP stands for Simplified Employee Pension. A SEP IRA is taxed like a traditional IRA but offers higher yearly contribution limits (up to 25% of your salary). 

They’re easy and cheap to set up and employers can make contributions for themselves and their employees.

Best for

• When you’re self-employed and considering having employees later on.
• Small business owners 
• When you want to make higher annual contributions than a traditional IRA.  

Disadvantages

• Business owners have to set up SEP IRAs. If you’re an employee and your employer doesn’t offer one, you can’t get one.
• Penalties for withdrawing money early.
• Required Minimum Distributions starting at age 70 1/2.

4. Spousal IRA

Typically, if you want to open an IRA you need to earn income. Luckily, there’s a loophole and it’s called a spousal IRA. If you’re married and your spouse is earning little or no income, you can open and contribute to a spousal IRA in his/her name. 

In terms of benefits and taxes, the spousal IRA is essentially just a traditional or Roth IRA. It’s a great way for a stay-at-home mom or dad to take advantage of a retirement plan, and for married couples to maximize their retirement savings.

Best for

• Couples where one spouse earns little to no income.

5. SIMPLE IRA 

This IRA is another option for small businesses, offering significant benefits for employers and their employees. Your employer has to match your contributions or make non-elective contributions. These are yours right away and you can take them with you if you decide to leave the company. 

Best for

• Small business owners.
• Self-employed individuals.
• When you want guaranteed employer matching contributions. 

Disadvantages

• You can only have a SIMPLE IRA if your employer offers one or you are the employer.
• Penalties for withdrawing money early.
• Required Minimum Distributions starting at age 70 1/2.

6. Self-Directed IRA

This unique type of IRA allows you to invest in more diversified portfolios. If you choose to go down this route, you will have more control over your investments. That can mean more profits, but it’s important to remember that it also comes with more risks^[2].

Self-directed IRAs offer a huge variety of investment instruments. You can invest in stocks, bonds, and mutual funds, but you can also experiment with real estate, precious metals, or even digital assets like cryptocurrency.  

Best for

• When you have a more sophisticated understanding of investing.
• When you want more investment options and flexibility.

Disadvantages

• Many of the available investment options expose you to higher levels of risk.

7. Non-Deductible IRA

If you don’t qualify to fully contribute to a traditional or Roth IRA, then a non-deductible IRA is a simple solution for you. While it doesn’t offer as many benefits as the other two options, whatever you invest in this plan does grow tax-free. 

Just remember you must proactively notify the IRS if you make contributions or you can run the risk of paying taxes twice.

Best for

• When your income is too high to make tax-deferred contributions to a regular IRA.
• When you maxed out your contributions to an employer-sponsored retirement plan.

8. Traditional 401(k)

Named after a section in the IRS code, the traditional 401(k) is a tax-advantaged retirement account offered by your employer. What you contribute and earn is tax-deferred, similar to a traditional IRA. 

Some employers will match a portion of your 401(k) salary deductions, and you only pay taxes on your contributions and earnings when you retire and withdraw the funds. 

Best for 

• When your tax bracket will be lower in retirement. 
• When contributing to it will put you in a lower tax bracket now
• If your employer’s 401(k) plan has advantageous terms.

Disadvantages

• No choice of providers: your employer does that
• Some 401(k) plans have limited investment options and high management fees.
• Some employers impose vesting schedules: you can only get your matching contributions if you work for the company for a minimum period of time.
• Penalties for withdrawing money early.
• Required Minimum Distributions starting at age 70 1/2.

If you don’t have access to a 401(k) or you don’t find the terms of your employer’s plan attractive, it might be worth looking into some 401(k) alternatives.

9. Roth 401(k)

Similar to a Roth IRA, this employer-sponsored retirement fund allows you to pay taxes on your contributions as you make them and withdraw your contributions tax free. The only funds that are not-tax exempt after retirement are your employer contributions. 

A Roth 401(k) doesn’t have the same income limits as a Roth IRA, meaning you can contribute to it even if you’re a high-earner. 

Best for 

• Younger savers 
• When you think you will be in a higher tax bracket in retirement 

10. Solo 401(k)

If you’re self-employed but you still want the benefits of a 401(k), the solo 401(k) is your answer. It still follows the same rules as your typical 401(k) but it has other benefits that some traditional plans don’t offer.

Since you own the business, you can contribute as the owner AND the employee, which gives you a pretty hefty contribution room. You can even include your spouse in the mix under some conditions.

Best for 

• Business owners with no employees 
• Self-employed individuals like freelancers and independent contractors etc.)

Disadvantages

• Only a business owner and spouse can participate

11. SIMPLE 401(k)

Let’s call this a hybrid between your SIMPLE IRA and a traditional 401(k). You make tax-deferred contributions to it and your employer has to contribute to it too. 

If you’re a small business owner, this account is pretty hassle-free to set up, but your employees’ contribution limit is lower than that of a traditional 401(k). 

Best for

• Small business owners 

Disadvantages

• Must be offered by an employer
• Lower contribution limits than a regular 401(k)

12. Safe Harbor 401(k)

If you’re an employee under this plan, not only will your employer make contributions to it, but you have immediate ownership of the funds (or are fully vested if you want to get fancy). 

This account is popular with small business owners because it’s less costly to set up and you don’t have to pass the IRS annual nondiscrimination tests.  

Best for

• Small business owners 

13. Profit Sharing Plan

As the name suggests, the company you work for shares its profits with you. This plan doesn’t give much control to you as an employee since the company decides how much they contribute or “share” .You also can’t make any contributions yourself as the company does it for you. 

Profit sharing plans can boost productivity and workplace satisfaction^[3]. Many employers offer them along with other types of retirement accounts. 

Best for 

• Employees working for financially profitable organizations. 
• When you want another retirement plan to supplement your existing one. 

Disadvantages

• Your employer decides whether to share profit or not. You have no say in the matter.

14. 403(b)

A 403(b) is a retirement plan for employees of non-profit organizations. The tax benefits and rules are similar to those of a traditional 401(k).

Best for

• Employees of non-profit organizations.
• Some public-school employees.
• Church employees.
• Some ministers.

Disadvantages

• Limited eligibility.

Consult With An Expert 

This review should give you a very basic understanding of tax-advantaged retirement accounts and the different types of available accounts. Remember that each one comes with more complex rules and requirements. It’s wise to consult with a qualified financial advisor or accountant before committing to a plan. 

The post What Are Tax-Advantaged Retirement Accounts? appeared first on FinMasters.

Discover how discipline and the right knowledge can bring you closer to early retirement.

In this post:

• Is It Really Possible to Retire Early?
• How Much is Enough to Retire Early?
• To Retire Early, Keep More of Your Paycheck
• How to Retire Early by Reducing Your Expenses
• How to Retire Early by Increasing Your Income
• What Should Your Investment Portfolio Look Like?
• The Biggest Hurdles to Retiring Early

Is It Really Possible to Retire Early?

Have you ever wondered where the traditional American retirement age of 65 comes from? My inner hippie suspects it was one way for “the Man” to minimize costs back when Social Security was established. Only 54% of adult men in the 1940s would live to see their 65th birthday^[1]. Traditional retirement is also a good way to get rid of the expensive older workers and make room for younger, cheaper labor.

Beyond those cynical notions, the number is arbitrary. The majority of existing pension plans and social benefit plans at the time (in America and the rest of the world) began paying out at age 65. The American government decided to let people access Social Security at 65, and it’s been synonymous with retirement ever since.

Other than gaining full access to Social Security, there’s no tangible reason you need to work into your 60s. It’s no safer or riskier mathematically than retiring at any other age. You can retire far earlier as long as you can fund your lifestyle without working. Fortunately, it’s entirely possible to do so without Social Security. Thanks to the internet, it’s never been easier for the average citizen to create a portfolio of income-producing assets.

Want to learn more about where you should put your retirement funds? Take a look at our guide to retirement accounts: An Introduction to Tax-Advantaged Retirement Accounts.

How Much is Enough to Retire Early?

Traditional financial wisdom says that you’ll need 80% of your working income to support yourself in retirement. Like the 65-year-old retirement age, the reasoning behind that number is arbitrary at best. The truth is that there’s no direct correlation between your working salary and retirement needs. You only need to save up enough to cover your spending in retirement, but you can even save $10,000 in six months!

For example: If you make $10,000 a month while working and expect to spend $2,000 a month as a retiree, why would you need $8,000 per month in retirement? You’re not saving for anything anymore, so there’d be no reason to build up a portfolio to support the extra income.

My theory for the origin of the 80% guideline is that traditional retirement advice also suggests saving 20% of your salary. If you save 20%, you spend 80%, implying that you’d need to support that in retirement.

That doesn’t really apply to people who retire early, though, since they usually save significantly more than 20% of their salaries in the first place.

You may also end up spending significantly less in retirement than you did while you were working, rendering the whole line of reasoning suspect.

How to Retire Early: The Shockingly Simple Path to Freedom

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Did you know? The average household retirement savings are $255,130. The median retirement savings paint a different picture. Median retirement savings among all families in the US are only $65,000. 

Calculating Your Retirement Number

In the 1990s, a group of college professors performed what’s now known as the Trinity Studies. They found that an investment portfolio split between stocks and bonds would survive inflation-adjusted withdrawals of 4% in almost all of the 30-year periods from 1925 to 1995. In simple terms, that means you have enough to retire once you save 25 times your annual expenses. That’s now known as the 4% rule, which is one of the most common modern benchmarks for financial independence. 

For example: Someone who spends $40,000 a year could support themselves indefinitely with a $1,000,000 portfolio of stocks and bonds. Someone who spends $20,000 per year would only need a $500,000 portfolio. 

Meeting the 4% rule isn’t a guarantee, but it’s surprisingly close. You can easily add in an extra margin of safety if you’re worried. Use a conservative estimate of your future expenses, save a little extra, withdraw less than 4% each year, or keep an enjoyable side hustle in retirement.

Want help figuring out how much you’ll need to save up to quit your job? Take a look at our guide to calculating that magic number: How to Calculate Your Retirement Number.

Retire Early by Keeping More of Your Paycheck

Now that you know what it takes to support yourself in retirement, the logical question is: “How do you get there as soon as possible?”

The answer is simple: Get your savings rate as high as possible. Your savings rate is equal to the amount you keep after paying expenses divided by your total earnings. 

For example: If you make $100,000 a year after taxes and save $25,000, you have a 25% savings rate.

That number is the best predictor of how early you can retire. The higher your savings rate, the lower your expenses, and the faster you can accumulate “enough.” Take a look at this retirement calculator to see the drastic effect your savings rate has on how soon you can retire.

Can you see how quickly those differences add up over time? If you kept up your savings rate of 40% for four months, you’d save almost $10,000. Not only is that twice the amount you’d save at a 20% savings in the same amount of time, but the relative power to support yourself with that money would be three times greater. Even better, that math works at every income level.

• At a 40% savings rate, 4 months of savings covers around 3 months of expenses.
• At a 20% savings rate, 4 months of savings only covers around 1 month of expenses.

American schools don’t teach this math. As a result, we tend to save minuscule portions of our incomes on average (usually less than 10%), which ensures that we have to work for decades before we can retire.

It doesn’t have to be that way, though. Even someone with an average income can save far more when they have the proper motivation. During the COVID-19 pandemic, Americans panicked and saved more than ever before. The average savings rate reached 33% in April 2020.

Want to learn more about how bad Americans seem to be with money? Take a look at our analysis of the data: Are Americans Bad at Saving?

How to Retire Early by Reducing Your Expenses

The best way to increase your savings rate is almost always to spend less money. It requires significantly less energy than earning extra income for most people, and there’s plenty of room for improvement in most budgets.

Perhaps counterintuitively, spending less is also more efficient than earning more on a per-dollar basis. Here’s why:

• Better Tax Efficiency: Whenever you earn a dollar, it gets taxed at your highest marginal tax rate. For example, an extra dollar for someone in the 24% tax bracket is only worth $0.76. When you spend one less dollar, it’s tax-free.
• Lower Needs in Retirement: To retire safely, you need enough money to support your expenses. When you spend less, not only do you build your savings faster, but you’ll also need to cover lower expenses in retirement.

To spend less, start by tracking your expenses with a free tool like Mint. Look for areas of waste that you can trim without reducing your quality of life. Pay special attention to your housing, transportation, and food costs. They’re the biggest line items in most Americans’ budgets and have the most potential for savings^[2].

Want more specific strategies for reducing your spending? Take a look at our favorite tips on budgeting and saving money.

How to Retire Early by Increasing Your Income

There’s a lot of controversy in personal finance circles over whether it’s better to focus on spending less or earning more, but that’s a false dichotomy. As in most things in life, the best path is to find a balance in the middle of the two extremes.

Earning more isn’t as efficient at raising your savings rate, but there’s no limit to the amount of money you can make. Meanwhile, you can only cut your spending so much. Sure, you could (try to) live in a tent in the woods, but that’s not a lifestyle most people care to have.

Want some fresh ideas for bringing in extra income? Take a look at our favorite ways to make more money: How to Start Making Extra Income.

What Should Your Investment Portfolio Look Like?

Earning more and saving less will both generate extra savings, but you need to put that cash to work in a healthy portfolio if you want it to support you in early retirement. It’s not enough to just keep it in a savings account somewhere.

You need your investment portfolio to:

• Harness compound interest to shorten your cash accumulation phase
• Preserve your wealth and match your tolerance for risk
• Produce enough income to cover your living costs and outpace inflation

There’s an infinite number of investing strategies that could generate enough passive income to support you in retirement. Low-cost index funds are a favorite in the early retirement community (and my investment strategy). If you’re willing to do the extra research, rental real estate can be a great tool for shortening the journey due to their natural bias toward cash flow.

It’s also always a great option to keep an enjoyable side hustle in retirement (especially early retirement) to help cover your living costs and keep you engaged. Using the 4% rule, a side hustle that nets you just $10,000 a year would allow your portfolio to be $250,000 smaller.

Want to learn how to start investing your money? Take a look at our guide to the basics: Investing 101: Investing For Beginners.

The Biggest Hurdles to Retiring Early

If you want to learn how to retire early and responsibly, you’ll need to study and prepare for some common challenges. In America, those are most likely to be:

• Healthcare: American early retirees may not be eligible for Medicare for decades. Make sure you incorporate the costs into your spending plan or come up with some other way to cover health costs.
• Sequence of market returns: The stock market averages higher returns than other asset classes, but it doesn’t grow by that average each year. If you happen to retire and start making withdrawals during an extended downturn, you could cripple your portfolio.
• Lifestyle goals: The retirement lifestyle you intend to lead has a huge impact on your planning. If you want to retire in modest style in a relatively low-cost area, retiring early is much more achievable. If you hope to jet around and live on champagne and caviar, you’ll need to focus a lot more on boosting your income (or reconsider winning the lottery).

Traditional retirement takes a ton of planning, and early retirement is even more demanding. You’ll need to account for the increased likelihood of something going wrong over 60 years as opposed to 20.

Make sure you do meticulous research before committing to an early retirement plan. It’s always a good idea to consult with a financial advisor or a Certified Public Accountant to ensure that your strategy accounts for all the necessary variables.

The post How to Retire Early: The Shockingly Simple Path to Freedom appeared first on FinMasters.

Among international destinations, Portugal, Mexico, and Panama are commonly cited as top retirement destinations^[10].

Here’s a full ranking of the top 10 countries for Americans to retire across the world:

The post Average Retirement Savings: By Age, State, Income & Race appeared first on FinMasters.

Let’s find out.

In this post:

• How Do You Live Off Dividends?
• Dividend Tax Considerations
• How Much Do You Need to Invest to Live Off Dividends?
• Can You Live Off Dividends?
• FAQ

How Do You Live Off Dividends?

Living off the passive income from your investments and becoming financially independent is a captivating idea, especially if you can do it earlier than you expected.

Fortunately, there are many ways to create an investment portfolio that can support you indefinitely. One popular option is to invest enough money in assets that pay enough dividends to cover your annual expenses.

To figure out the amount of money you’d need to invest to live off dividends like this, you’ll need to define two variables: the amount you plan to spend per year and the dividend yield of your intended portfolio.

Once you have them, divide the former by the latter to get your portfolio value.

The best way to start building a spending plan for the future is to assess your current expenses and adjust them as necessary. I always suggest plugging your debit or credit card into a digital budgeting tool so you can automatically track all your expenses in one convenient location.

You could write everything down using pen and paper the old-fashioned way, but why would you? It’s too easy to forget cash transactions, make typos, or give up on the practice altogether that way.

Learn More: If you’ve been tracking your spending for a while and want to start building a budget, check out our helpful introduction to the subject: Budgeting 101: How to Budget Your Money.

What’s a Realistic Dividend Yield?

Once you know how much you plan to spend each year, you’ll need to figure out what kind of dividend yield you can reasonably achieve. While your mileage will vary, you can generally expect a dividend yield roughly between 1% and 6%.

Your investment portfolio’s total dividend yield will depend on its composition. Here are some examples of average historical dividend yields on some popular assets for reference:

• Vanguard S&P 500 Index Fund ETF: 1.85% long-term average¹
• Ford Stock: 4.88% average over the last five years²
• Schwab US Real Estate Investment Trust (REIT) ETF: 2.67% over the last five years³

While you can’t know for sure what dividends an asset will pay out in the future, you can get a good idea by reviewing its historical yields. You should be able to find them featured prominently on the asset’s page at your brokerage or using independent databases online.

How to Evaluate Dividend Sustainability

When you’re building a portfolio of dividend-paying assets, it’s tempting to pick the ones with the highest yields, but that’s a risky strategy. There’s a lot more to consider when evaluating the value of a stock than its dividend. In fact, those with the highest yields can be the riskiest.

To calculate the dividend yield of a stock, you divide its annual dividend by the price of one share. For example, if a stock pays a $5 dividend yearly and costs $100, it has a 5% dividend yield.

That means there’s an inverse relationship between yield and stock price. If one goes down, the other goes up. Someone who picks stocks for their increasing yields could accidentally acquire assets that are dropping in price, which is a quick way to lose money.

Because of this, you should always assess the sustainability of an asset’s yield before adding it to your portfolio.

For example, you could examine its dividend payout ratio, which equals its dividend divided by its net income. A company that nets $1,000,000 for the year and pays out $100,000 to its investors has a 10% payout ratio.

If it’s over 100% and has been for a few years, the company is paying out more than it makes, which isn’t possible forever. Conversely, a ratio that has been steadily increasing for a decade could be a sign that the business is maturing healthily.

If you’re going to live off dividends from your portfolio, make sure you do this kind of due diligence before you invest in anything. You want those dividends to last.

Dividend Tax Considerations

Don’t forget to factor taxes into your dividend calculations. If you’re receiving your dividends from equities in a traditional 401(k), IRA, or taxable brokerage account, they will be taxable income.

However, they’ll be subject to different tax rates. With a traditional retirement account, you won’t pay taxes on dividends while you reinvest them. Once you start taking them as distributions, though, they’ll be taxable at ordinary income rates.

If you take your dividends from a taxable brokerage account, they will receive one of two tax treatments, depending on whether they are:

• Qualified: These are taxable at the discounted long-term capital gain rates of 0%, 15%, or 20%.
• Ordinary: These are taxable at ordinary income rates, which range from 10% to 37%.

If your dividends come from after-tax accounts like Roth 401(k)s or IRAs, you can avoid the issue altogether. You won’t pay taxes on reinvested dividends or those you take as distributions.

Make sure you know the significance of these two types of taxation, as they can skew your numbers significantly.

For example, $30,000 in qualified dividends taxable at 15% is $25,500. The same amount in ordinary dividends taxable at 24% is $22,800. That’s $2,700 less each year and $225 less per month.

It’s always a good idea to get personalized tax advice regarding the implications of any investment strategy. Consider discussing your approach with a tax expert like a Certified Public Accountant or Enrolled Agent, or read what the IRS has to say about dividends.

Learn More: If you need to brush up on the different types of personal income taxes, take a look at our overview of the subject: Taxation 101: How Do Taxes Work For Individuals?

How Much Do You Need to Invest to Live Off Dividends?

How much you need to invest to live off dividends is a function of your annual expenses and the dividend yield of your portfolio. Let’s look at some realistic examples of portfolios you could create to live off dividends in various scenarios.

These numbers are, of course, estimates. You can never be entirely sure how much you’ll spend or exactly what dividend yield you’ll receive in the future. Both amounts can and will fluctuate, so make sure you build in a buffer according to your risk tolerance.

Learn More: While inflation will probably increase your annual expenses over time, dividend payments tend to keep pace with it. To learn more about how inflation would affect your retirement, read this comprehensive guide to the concept: How Inflation Works: An Illustrated Guide for the Rest of Us.

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Can You Live Off Dividends?

While you can live off the dividends from your investments, it might not be the optimal retirement strategy. You’re generally better off optimizing your portfolio’s total return than you are chasing a high dividend yield just for the sake of dividends.

While there’s something instinctively satisfying about living solely off dividends, it’s usually not necessary to distinguish between living off dividends versus a portfolio of equities in general.

How Much Do You Need to Invest to Live Off Dividends?

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In truth, there’s no practical difference between distributing money from your portfolio through dividends or through selling assets.

The only difference to an investor would come from a variance in tax rates when taking distributions from a taxable brokerage account. In most cases, though, that will work out in favor of selling assets over taking dividends anyway.

If you manually sell portions of your retirement portfolio, you can use the first-in, first-out basis, which means the first asset you sell is the first one you acquired. These should always be subject to long-term capital gains taxes if you’ve been investing for years. 

Meanwhile, ordinary dividends are subject to the less favorable ordinary income tax rates.

You’ll also have more control over the timing of your earnings if you sell portions of your portfolio manually. Shareholders don’t get to decide when they receive their dividends or how much they’ll be.

If you prefer a buy and hold strategy but you still want market-beating growth, there’s a variant of dividend investing that you should consider – Dividend growth investing

Frequently Asked Questions

Learn more: $3,000 per month in passive income is a common goal among investors. Check out our guide below for a deeper analysis of various ways to reach it: How Much Money Do I Need to Invest to Make $3,000 a Month?

The post How to Live Off Dividends and How Much You Need to Retire appeared first on FinMasters.

While many worry about not saving enough, the opposite happens surprisingly often. 27% of Americans with a college-educated parent received an inheritance in 2019, with a median value of $92,700^[1]. That’s a lot of people with significant savings left over when they pass away.

That raises an important question: what happens to your 401(k) when you die? Who gets the money, when, and how? This guide will give you the information you need to prepare for and manage 401(k) inheritance transactions properly, whether you’re the original owner or the beneficiary.

In this post:

• 401(k) Beneficiary Rules
• Problems With Probate
• General Tax Considerations
• 401(k) Account Transfer Options and Their Tax Implications
  • Spousal Beneficiaries
  • Non-Spousal Beneficiaries

401(k) Beneficiary Rules

When you die, your 401(k) goes to the designated beneficiary of the account. If you have a living spouse at the time of your death, they’ll be the default beneficiary by law.

For you to pass your retirement account to a non-spousal beneficiary, your partner will typically have to waive their rights to the benefits.

Otherwise, even if you named another person on your beneficiary forms (say, when you opened the account), your spouse will still be entitled to the money.

If you’re unmarried or have no living spouse at the time of your death, you can elect to leave the funds to whomever you wish. That can include multiple people, in which case you can split the proceeds at your discretion.

There are two priority levels for beneficiaries:

• Primary: These are the people who get first dibs on your 401(k). If one of several primary beneficiaries is deceased or unavailable, their share will go to the others.
• Contingent: These people will only get the funds from your 401(k) if all primary beneficiaries have passed away or are unavailable.

Problems With Probate

Probate is a legal process during which a court validates your will, and its executor ensures your estate goes to the designated parties. If you die without a will, the probate court will assign someone to handle your estate (usually a close relative).

You should avoid letting your assets go through probate upon your death when possible. The process can delay the transfer by months or more and deplete the value of your estate.

The executor has to register paperwork demonstrating your death, get the courts to approve the will, take control of your accounts, and then distribute the assets, which can drag on for a long time.

In addition, the executor usually uses the estate to pay for legal costs and will have to pay off your creditors if you had outstanding debts upon passing. 

Creditors can’t normally pursue your 401(k) (unless they’re the IRS), but all bets are off if it’s part of your estate during probate.

Fortunately, naming a beneficiary on a retirement account keeps it separate from the rest of your estate and allows for a simple transfer upon your death.

What Happens to Your 401(k) When You Die?

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You have to name a beneficiary when you open your 401(k), so it typically won’t have to go through probate unless:

• All your primary and contingent beneficiaries are deceased or unavailable when you die
• You name your estate as the beneficiary of your 401(k)

Because of this, you should update your named beneficiaries after any life events that may impact who you want to receive your funds, like getting married, having children, going through a divorce, or a beneficiary passing away.

General Tax Considerations

As if death weren’t inconvenient enough, it can present some pesky tax issues. While there are typically few problems for the deceased, beneficiaries often have to do a lot of planning to navigate account transfers successfully.

I’ll go into further detail later when I talk about the specific transfer options for 401(k)s, but here are some general guidelines.

Traditional vs. Roth 401(k)s

Beneficiaries of a 401(k) use the same tax treatment for distributions as the original owner. That means if the account was traditional (funded with pre-tax dollars), the beneficiary’s withdrawals or distributions are generally taxable.

If it was a Roth 401(k) and funded with post-tax money, any distributions will not be taxable.

Learn More: Do you understand the difference between Roth and traditional retirement accounts? Take a deep dive into the topic here: Roth vs. Traditional: What’s the Difference?

Estate Taxes

The IRS rarely misses an opportunity to tax you, and death is sadly no exception. There is such a thing as a death tax, though people usually refer to it as the estate tax.

If you have enough left in your 401(k) when you die to trigger estate taxes, you’ll pay between 18% and 40% to the federal government on the amount above your exemption.

Fortunately, the threshold to qualify for estate taxes is surprisingly high. In 2021, there’s a lifetime exemption of $11.7 million for all gift transfers. That includes your estate.

That’s why most people don’t have to worry about this too much. However, your exemption will be lower if you gave gifts above the annual $15,000 per person threshold during your lifetime.

401(k) Account Transfer Options and Their Tax Implications

When you die, the IRS generally requires plan administrators to transfer your 401(k) to the proper beneficiaries no later than the end of the following year.

If you passed away in January 2021, your beneficiaries would receive their payouts, or control of the 401(k), by December 31, 2022.

However, as you probably know, 401(k)s have rules that limit access to the funds inside them. They’re retirement accounts, after all, so they’re designed to prevent people from taking the funds out before retirement.

Unfortunately, these limitations don’t necessarily disappear when the original account holder passes away. There are still restrictions on how the beneficiaries can receive the funds. That can complicate matters.

Spousal Beneficiaries

The inheritance of a 401(k)  is usually smoothest when it’s between spouses. There are three ways for surviving spouses to receive the funds.

Taking Over the Account

Spouses can elect to leave the 401(k) in the original owner’s name. They can then access the funds without the 10% early-withdrawal penalty, even if neither spouse was age 59 ½.

If they choose this option, they have to take required minimum distributions (RMDs) on the original owner’s schedule, which starts when they would’ve turned 72.

Important Note: Calculating required minimum distributions and dynamically adjusting your tax planning accordingly is a complex and delicate matter. The IRS will impose a whopping 50% penalty on any balance remaining in a retirement account that shouldn’t be there, so you should strongly consider talking to a tax professional for help with RMDs.

Rollover into a new account

Spouses can elect to close the inherited 401(k) and roll the proceeds into their own 401(k) or IRA. There are two general account options:

• Inherited IRA: These specific IRAs allow spouses to take distributions after a rollover without triggering the 10% early withdrawal penalty, regardless of age. The spouses can then take RMDs based on their single life expectancy or over the next ten years. They can’t contribute further to an inherited IRA.
• Regular IRA or 401(k): If spouses roll over the 401(k) into a regular defined contribution account, they’ll treat it as if it was theirs all along. That means the 10% penalty applies to further withdrawals from the new account, and RMDs will begin when they normally would (at age 72).

Rolling the funds into one type or the other depends on both spouses’ ages, incomes, balances, and plans for the future. Again, consider consulting a tax professional before choosing one.

Distributions

Spouses can elect to take distributions from an inherited 401(k) without rolling it into another tax-advantaged account. These distributions will not be subject to the 10% early withdrawal penalty.

The distributions can occur in a single lump-sum or periodically, but a single lump sum can potentially create a massive tax bill since it can push the recipient into higher tax brackets.

If the spousal beneficiary chooses periodic distributions, they can elect to receive them over their single life expectancy or the next ten years.

Keep in mind that while these are the legal options put forth by the IRS, the terms of an individual 401(k) might require one or the other. Make sure you check the rules that apply to your account or the one you’re inheriting.

Non-Spousal Beneficiaries

Thanks to the recent passage of the SECURE Act, there are a lot fewer options available to non-spousal beneficiaries. In some ways, that makes it simpler for them to inherit a 401(k), though it usually costs more in taxes.

Non-spousal beneficiaries have a ten-year window to take distributions equal to the amount of the account balance. By taking distributions in fewer tax years, inheritors will likely reach higher tax brackets and miss out on years of deferred growth.

There are exceptions to the ten-year requirement if the non-spousal beneficiary qualifies as an “eligible designated beneficiary.” These include the following:

• Permanently handicapped or chronically ill;
• Less than ten years younger than the deceased;
• Minors (their ten-year clock starts at age 18).

These eligible designated beneficiaries can take distributions over their single life expectancy, much like a spousal beneficiary.

Consider Talking to an Estate Planner

As you can see, estate planning can get extremely technical. The information above is just an introduction to what happens to your 401(k) when you die.

Finding the best tax strategy for an inherited 401(k) is a deeply involved process, and the cost of mistakes is high. One slip-up could mean leaving your life savings to your ex-spouse or mishandling an inheritance, and losing thousands in unnecessary taxes.

If you have a sizeable 401(k), if you have recently inherited one, or if you expect to inherit one, it’s a good idea to talk to an estate planner or tax expert to help you make sure you handle your next steps correctly.

Further Reading: Are you trying to decide whether a 401(k) or an IRA works best for your retirement plans? Take a look at our comparison of the two: 401(k) vs. IRA: The Best Type For You

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When you’re deciding whether to open a 401(k) vs. IRA, it’s helpful to know what these accounts are, how they’re similar and different, and how each of them can help you achieve your retirement goals. (Pro tip: it might make sense to have both!)

401(k) vs. IRA: The Similarities

First, let’s go over the similarities between these two popular retirement accounts. 

Investment Account Types

One common misconception for new investors is that simply having a 401(k) or IRA automatically means that you’re investing in the stock market. However, 401(k)s and IRAs aren’t investments themselves: they’re just accounts where you can hold investments.

You can think of them as the wallet, not the cash.

Once you open a 401(k) or IRA, you’ll need to decide what kinds of investments to purchase inside your account. If you skip the asset allocation step, your money might just be sitting in cash inside the account. It wouldn’t be growing at all! Later, I’ll touch more on the different kinds of investment choices you may have in a 401(k) vs. IRA.

Retirement Tax Advantages

401(k)s and IRAs are both types of tax-advantaged retirement accounts. 

With a regular taxable investment account, you invest money you’ve already paid income taxes on. Every transaction you make is a taxable event, so you’re getting taxed on both sides (contribution and sale/withdrawal).

In a tax-advantaged retirement account, you’ll only be taxed on one side. If you choose a traditional pre-tax 401(k) or IRA, you’ll make tax-deductible contributions. You’re funding the account with money that the government won’t tax that year. You’ll only pay taxes when you withdraw the funds in retirement. 

There’s also the option to choose a Roth, or post-tax, version of a 401(k) or IRA. This works the opposite way: you’ll pay regular income taxes on your money the year you contribute it. You won’t be taxed when you withdraw it in retirement.

Learn more about the difference between traditional and Roth accounts.

Restrictions on Withdrawals

Because 401(k)s and IRAs are meant to encourage retirement saving, neither of them makes it easy to just get that money out whenever you want it. You’ll face taxes and penalties if you try to withdraw funds before age 59 ½, unless you qualify for an exception. 

A Roth IRA is unique in that you can always withdraw your contributions without penalty; you just can’t withdraw any profits you’ve made. For instance, if you’ve contributed $50,000 to a Roth IRA and it’s grown to be worth $75,000, you can withdraw the $50k of contributions but not the $25k of profits.

401(k) vs. IRA: The Differences

When you’re trying to decide on opening a 401(k) vs. IRA, the differences are more important than the similarities, so let’s dive in! 

Account Management & Eligibility

The biggest difference between a 401(k) vs. IRA is who manages the accounts and who is eligible to get them.

A 401(k) is an employer-sponsored retirement account, so you can only get one if your employer offers one and you meet their employee participation standards (e.g. you may have to work at the company for a certain amount of time before becoming eligible). The company chooses the 401(k) provider and sets up the plan.

An IRA is an account you open and manage as an individual. Anyone who is under the age of 70 ½ and is earning taxable income can open and contribute to an IRA. That means you can invest in an IRA even if you’re self-employed or have a side gig; your account isn’t tied to a company you’re working for. You can open your own IRA at many popular brokerages, including Fidelity, Vanguard, Wealthfront, and others.

Contribution Limits

Both accounts limit how much you can contribute in a year, but the limits for a 401(k) are much higher. They also both allow for catch-up contributions after age 50. 

As you can see, if you want to invest more than $6-7,000 a year for retirement, an IRA alone wouldn’t be enough.

Investment Selections & Fees

Because 401(k) plans are arranged by your company, you don’t have much control over what investment products will be available to you, or what fees they’ll charge.

401(k) vs. IRA: The Best Type of #Retirement Account for You

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The average 401(k) plan offers 8-12 investment choices^[1], which are usually some combination of mutual funds. They might have a large-cap stock fund, a small-cap stock fund, a bond fund, a target-date fund, and so on, with a mix of riskier or more conservative investments. 

An IRA gives you a much broader range of choices. Within an IRA, you can purchase almost any type of investment, including:

• Index funds & mutual funds
• ETFs
• Individual stocks
• REITs (real estate investments)
• Bonds
• Annuities

In short, an IRA gives you a lot more freedom to choose your investments, while a 401(k) locks you into whatever packages your company picks.

If your employer’s 401(k) offerings have high fees or don’t meet your investment objectives, you might want to stick to an IRA or open an IRA to supplement your 401(k).

401(k) Employer Matching

Depending on your employer, matching can be an incredibly significant benefit of a 401(k). Essentially, your company will add extra money to your 401(k), up to a certain percentage of your salary and contributions. 

Some companies don’t offer a match, but for the ones that do, it’s an extra incentive to contribute to the plan and stay at the company. That’s because matches can be subject to different vesting schedules, which means if you leave the job before your matches have fully “vested,” you’ll only get to keep your own account balance and possibly a certain percentage of the match. 

As long as you stay at the company long enough for the match to vest, it’s free money that you definitely don’t want to pass up!

How to Start Investing in a 401(k) and/or IRA

Now that we’ve reviewed the similarities and differences of a 401(k) vs. IRA, it’s time for action. Where should you start in order to maximize the advantages of these accounts?

Here are the steps I recommend:

1. Review your employer’s 401(k) options, if applicable. The biggest things to look for are (A) what funds are available for investing inside the plan and (B) what the expense ratio is for each fund since you’ll want to avoid ones with high expense ratios. If you don’t have an employer who offers a 401(k) or their options don’t work for you, skip straight to opening an IRA.
   
2. If your employer offers a 401(k) match, start by contributing just enough to get the match. Like we talked about above, if they match 50% of a 6% contribution, you should set your 401(k) contribution at 6% to get the full match. As long as the expense ratios aren’t higher than the match percentage, this is free money. Talk to your HR department if you have questions about setting up your 401(k).
   
3. When you’re contributing enough for the match and still want to invest more, open an IRA next. You can easily do this online with a brokerage of your choice. Max out your IRA if you’re able to. If your employer doesn’t offer a 401(k) match, funding an IRA should be your step 1. If your 401(k) is traditional, consider opening a Roth IRA to go with it, to maximize the advantages of both types.
   
4. Once you’ve maxed out your IRA or have gotten on track to do so, you can revisit and increase your 401(k) contributions if you still have more money you’d like to invest. Contribute as much as you feel comfortable. 

5. If you have any income from self-employment, you can also explore other account alternatives like a solo 401(k) and SEP-IRA.

The absolute best-case scenario is to be able to max out your IRA and your 401(k), but don’t feel bad if that just isn’t possible. Only 13% of 401(k) participants in a 2018 Vanguard survey were maxing out their contributions, and many of those people were older and later in their careers^[2]. The most important thing is just to do what you can. It’s your financial journey and you don’t need to compare it to anyone else’s. Focus on your goals and look forward to the future!

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What Is A Target-Date Fund?

A target-date fund is a mutual fund that automatically rebalances its asset allocation over time based on a pre-selected retirement date.

For example, if you’re 32 years old in 2022 and plan to retire at age 65, you’d choose a target-date fund with a target date of 2055.

Target date funds are also known as  “life cycle” or “time horizon” funds. They generally start out more aggressive, then get more conservative as your “target date” approaches.

How Do Target-Date Funds Work?

If target-date funds could be summed up into one catchphrase, it’d be Billy Maye’s Set It & Forget It. 

Here’s why…

Target date funds start out with a higher percentage of stocks and aggressive investments, and then gradually shift to a mix of more conservative bonds and cash as your target date approaches. That way, you’re less likely to lose money right before you retire.

As an investor, all you have to do is choose one fund that lines up with when you want to retire and keep making contributions into that fund. Then, sit back and relax as it adjusts and rebalances over time. 

It’s investing on autopilot. One fund to rule them all.

Target date funds are so popular because…

Rather than having to research a bunch of individual funds, choose the perfect mix of stocks and bonds, and rebalance everything by yourself…

You just choose one fund that does it all for you. 

It takes the guesswork out of building wealth and makes it easy for anyone who’s nervous to get started investing.

Understanding Target-Date Fund Glide Paths

So what makes target-date funds so magical? 

In short, target-date funds are able to provide a hands-off approach to investing because they automatically rebalance based on a glide path. 

In simple terms, a target-date fund glide path is how your asset allocation shifts from “aggressive” to “conservative” as retirement gets closer. This process is called “de-risking.”

There are two primary types of glide paths a target date fund may follow: “to retirement” and “through retirement.” 

• To retirement glide paths end when you retire. So if your target-date fund is for 2050, it will reach its most conservative point in 2050. 
• Through retirement glide paths continue for maybe 10 years or so after you retire. So if you have a fund for 2050, it may not reach its most conservative point until 2060. The idea is that your retirement could last 20 or 30 years. So giving your assets more time in the growth phase could (theoretically) lead to more money in retirement.

A target-date fund with a through-retirement glide path can provide backup funds in the happy event that you live longer than expected.

What Is An Example of a Target-Date Fund?

Vanguard is the top target-date fund provider, so let’s use them as an example. 

Vanguard currently has 12 different target-date funds to choose from. Your choice will depend on the year you were born and when you want to retire:

Target Date Funds Pros and Cons

There’s a lot for beginner investors to love about target-date funds. But they aren’t perfect. Here’s a quick overview of the pros and cons:

Are Target-Date Funds a Good Investment?

So, are target-date funds a good investment? That’s the million-dollar question.

Unfortunately, the not-so-million-dollar answer is: it depends.

That said, here are a few scenarios to help you decide.

Target date funds may be right for you if:

• You’re brand new to investing
• You’re looking for the easiest way to save for retirement
• You don’t want to worry about rebalancing your portfolio or making other complex decisions
• You want to set it and forget it
• You like the idea of picking one fund based on your retirement date and letting it ride

On the contrary, you may be better off skipping target-date funds and building your own portfolio if:

• You’re an investing nerd who loves digging into data
• You want more control over your portfolio
• You’re willing to spend time monitoring and adjusting your investments over time

Quick tip:  Investing is never an all-or-nothing approach. If you like the idea of target-date funds and building your own portfolio, do both. The world is your oyster, baby!

FAQs

What’s a Good Expense Ratio for a Target-Date Fund?

The average target-date fund has an expense ratio of 0.34%, according to Morningstar research. So a good expense ratio would be anything lower than or equal to the average. 

For instance, Vanguard’s Target Retirement Fund expense ratio is 0.08% — about 76% less than the industry average. 

Quick tip: Target date fund costs continue to decline every year, suggesting they may become even more affordable as time goes on. 

How Do I Choose a Target-Date Fund?

Choosing a target-date fund is relatively easy. In most cases, all you need to do is log into your 401(k) or investment account and search for a target-date fund that correlates with your expected retirement date. 

So if you want to retire in 2045, find a target date fund with “2045” in the title.

Once you’ve found a fund you like, transfer enough money to your investment account to buy it. You can also set up automatic contributions if you don’t want to manually buy shares each month.

Quick tip: Most target-date funds end in “0” or “5” — i.e. 2045 or 2050. So if you plan to retire in 2048, you could choose 2045 to be more conservative, 2050 to be more aggressive, or you could split the difference and invest in both. 

Are Target-Date Funds Low Risk?

Target date funds are designed to be low-risk if you buy and hold them for the long term. However, all investments carry risk and returns are never guaranteed.

It’s important to read a fund’s profile or prospectus carefully to make sure you understand the level of risk involved. 

What’s the Difference Between Target-Date Funds and Index Funds?

Target date funds are a type of mutual fund that invests in a mix of stocks, bonds, and other assets. This mix starts out aggressive and slowly starts to shift as you get closer to retirement.

Index funds, on the other hand, track a specific market index, such as the S&P 500. This means they’re made up of the same stocks that are in the index and nothing else.

As a general guideline, it’s a good idea to invest in several index funds to make sure you’re properly diversified if you choose to build your portfolio around index funds. In contrast, you may only need one target-date fund to get the job done. 

What Should I Do With My Target-Date Fund After Retirement?

The short answer is nothing. Even after your retirement date passes, your fund will continue to invest based on its glide path or final asset allocation mix. If you’re happy with it as-is, you can sit back and keep on letting it do its thing.

However, if you think your target-date fund is a bit too conservative, you could sell some of it and buy more stocks or stock equivalents instead.

You may also sell all or part of your holding if you need money for living expenses or if your retirement account has mandatory distributions starting at a fixed age, like a conventional 401(k) or IRA.

You may pay taxes on whatever you sell, depending on your account type. For instance, you could be subject to:

• Ordinary income tax on traditional 401(k) and IRA distributions
• Capital gains tax on regular brokerage account distributions
• No tax on Roth 401(k) or IRA distributions (because you already paid taxes upfront)

To learn more about taxes on retirement accounts, check out our guide on Roth vs. traditional retirement accounts.

The post What Are Target-Date Funds and How Do They Work appeared first on FinMasters.

And just in case you want to know more than Andy Dwyer, Roth is Delaware Senator William Victor Roth, who laid down the basis for Roth accounts as part of the Taxpayer Relief Act of 1997.

Tax Timing: The Fundamental Difference

The fundamental difference between Roth and traditional retirement accounts is in their tax timing. They trigger taxable income at opposite ends of the investing cycle. You either pay taxes when you make your contributions (Roth) or when you take distributions (traditional).

Keep in mind that while the IRS taxes money differently as it comes in and out of Roth and traditional accounts, they treat it the same (tax-free) while it grows within both types. Your investment earnings will not be taxed in either case.

Roth vs. Traditional IRAs

401(k)s and Individual Retirement Accounts (IRAs) are two of the most popular types of retirement plans. They’re both defined-benefit contribution plans, and they’re the ones that usually offer Roth variations.

Other than the difference in tax timing, Roth and traditional 401(k)s follow the same rules. They have the same contribution limits and distribution requirements, and there are no income limitations for either version.

Looking for alternatives to the common types of retirement accounts? Take a look at the best options here: 401(k) Alternatives.

There are a few extra differences between Roth and traditional IRAs. Those details have a significant impact on their place in your retirement plan.

Here are the ways that Roth and traditional IRAs differ other than their taxation.

Contribution Rules

To contribute to a retirement account, you’ll need employment or self-employment income. All retirement accounts limit your contributions to what you make during the tax year. That means you might not always earn enough to contribute the full legal limit to a retirement account.

In some cases, you can also earn too much. Roth IRAs are one of them. If your modified adjusted gross income (MAGI) gets too high, your Roth IRA contribution limit will decrease. After another $10,000 to $15,000, it’ll disappear completely.

Here are the phase-out ranges for each filing status in 2021:

• Single or Head of Household: $125,000 to $140,000
• Married Filing Jointly or Qualified Widow(er): $198,000 to $208,000

If you’re Married Filing Separately, the phase-out range depends on whether you lived with your spouse during the tax year. Those who lived apart can use the Single filer range. But for those who lived with their spouse at all, the phase-out range starts with the first dollar and ends at $10,000.

Traditional IRAs don’t have any income limitations for contributions, but you might not qualify for the entire tax deduction if you (or your spouse) try to deduct 401(k) contributions and IRA contributions at the same time.

Here are the phase-out ranges for deducting contributions when you or your spouse are covered by a 401(k) or another employer-sponsored plan:

• Single or Head of Household: $66,000 to $76,000
• Married Filing Jointly or Qualifying Widower: $105,000 to $125,000

Note that these are relatively low income limits. It’s usually best not to try to contribute to a traditional IRA if you’re already contributing to a traditional 401(k).

If you’re not covered by a 401(k) plan at work, your traditional IRA contributions will always be deductible.

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Distribution Rules

Roth IRA distribution rules are more favorable for the taxpayer than traditional IRA rules. You’ve already paid tax on the money, so the IRS is much less concerned with what you do with it. In addition to being tax-free, they have the following advantages:

• No Required Minimum Distributions (RMDs): Traditional IRAs require that their owners start taking distributions from their accounts once they turn 72. Your RMD amount is a function of your account balance and remaining life expectancy. Failure to take RMDs will cost you 50% of the required distribution in penalties.
• Accessibility of Contributions: Because contributions to Roth IRAs are after-tax, you can distribute them from the account at any time without penalty or taxes. With other retirement accounts, there’s no way to access any of the assets before age 59 ½ without facing penalties, unless you meet one of the few exceptions. 

These Roth IRA advantages aren’t always going to come into play. You’ll probably want to use your retirement funds, so the IRS might not need to force you to take distributions. Taking your contributions out early will sabotage the growth of your retirement accounts, so it’s rarely a good idea.

Still, both benefits offer extra flexibility. Some people might want to have a fund with no RMD tucked away (and still earning) for late in their retirement, or even to pass on to their children. It might give others peace of mind to know that they can take cash out of their Roth IRA if they ever fall on hard times.

Roth vs. Traditional: The Practical Impact

Conceptually, the differences between Roth and traditional accounts are easy enough to understand. It’s still hard to grasp the practical implications without seeing the math. Let’s take a look at an example to see how choosing one over the other would play out.

Roth vs. Traditional: Which is Better?

In John’s example, the final retirement fund totals were virtually the same. But if he had done things just a little differently, the results would have strongly favored one or the other.

The example also assumed that tax rates stayed consistent across his entire working career and eventual retirement. If they didn’t, choosing one or the other account type would be noticeably superior.

Generally, you should try to take the tax deduction when your tax rates are highest. If that’s while you’re working, use the traditional account. If that’s in retirement, use the Roth account.

Two factors affect your tax rate:

• Where your income puts you in the tax brackets
• Changes in the tax brackets themselves

Unfortunately, it’s impossible to predict when your effective tax rates are going to be higher or lower. Most people make more while they work and less in retirement, but many experts believe tax brackets will go up in the future. Many people also have fewer deductions in retirement.

Fortunately, choosing between Roth and traditional requirement accounts isn’t a binary decision. You can, and probably should, take advantage of both types.

Why It Makes Sense to Invest in Both

People have a bad habit of seeing their options as black and white. We vote Republican or Democrat, drink coffee or tea, and love cats or dogs. But that tends to backfire more often than not. It’s definitely something to avoid when choosing between Roth and traditional retirement accounts.

In this case, permanently picking one over the other is like deciding that turning left is better than turning right. You’ll get to your destination much faster if you take advantage of both options.

Let’s take a look at why it makes more sense not to limit yourself.

Contributing During Working Years

The primary reason to contribute to either Roth or traditional retirement accounts is to take the tax deduction when your marginal tax rates are highest. Your working career will probably last for decades, so you’ll have to constantly reassess how your rates compare to what you expect to pay in retirement.

People usually enter the workforce in their early twenties and retire somewhere around their sixties. Most people earn more toward the end of their careers. Because America’s income tax system is progressive, raising your earnings will also raise your marginal tax rates.

Taking Distributions in Retirement

So far, it seems like the best choice would be to contribute to Roth accounts until your income exceeds what you plan to need in retirement. At that point, you could switch to traditional retirement accounts to maximize your deductions.

Unfortunately, it’s not that simple. In reality, it’s difficult to know for sure what you’ll need to support yourself in retirement. You might be able to live happily off $30,000 a year when you’re 25, but you’ll probably need more when you’re 65. Just how much more you’ll need is impossible to predict. Lifestyle inflation and potential health complications will both have an unknowable impact on your future budget.

Looking for ways to live a cheaper lifestyle in retirement? Check out some of our best ideas: 11 Easy Money-Saving Tips for Seniors

Even if you knew exactly how much income you’d need to afford your future lifestyle, it’s unlikely that overall tax brackets would remain the same. Without knowing how they’ll change, you have no idea whether you’d be better off with the deduction while working or in retirement.

And if anything, it’s likely that tax rates will trend up, given the federal government’s overspending problem. Falling into a lower tax bracket personally while overall rates go up would produce an unknowable net effect. Most current proposals for raising taxes focus on the higher brackets and would have little impact on less wealthy workers, but that trend could also change.

The bottom line is that it’s impossible to know with absolute certainty when you’ll benefit most from Roth or traditional retirement accounts. You can make educated guesses, but contributing to both is the best way to hedge your bets.

Roth or Traditional #Retirement Accounts: Why Not Both?

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Having Both Lets You Leverage Asset Location

Having both types of retirement accounts also helps you diversify your investment holdings. Diversification is one of the fundamental principles of smart investing: it’s always safer to put your eggs in multiple baskets, rather than just one. People usually take that to mean that you should invest in multiple asset classes, but it also means you should split your investments between multiple types of accounts.

Diversifying your account types intelligently is also known as optimizing your “asset location.” With both Roth and traditional retirement accounts, you can put asset classes in accounts that get the most efficient tax treatments for their attributes. 

Having multiple asset locations also allows you to smooth out your income levels.

Consider a Traditional 401(k) and a Roth IRA

One of the most common ways people split their funds between retirement accounts is by contributing to a traditional 401(k) and a Roth IRA. Roth IRAs allow you to take out your contributions without any penalties and avoid Required Minimum Distributions (RMDs), but Roth 401(k)s don’t. An RMD is a mandatory annual disbursement from your account starting at the age of 70 1/2.

The Roth IRA’s exemption from RMDs can be a real advantage. Lifespans are increasing, and accounts with mandatory disbursements could run out while you’re still alive. Your Roth IRA can remain in reserve (and still earning) for late in your retirement.

If you don’t use it you can pass your IRA (and its tax-free privilege) to your heirs.

While this split works for many people, it’s not going to be viable for everyone. Some people’s employers don’t offer 401(k) plans, and self-employed people can’t access 401(k)s unless they start their own.

In any case, it’s best to consult an expert before committing to Roth or traditional retirement accounts. Retirement planning is extremely nuanced, and it’s always safest to consult with a financial advisor or Certified Public Accountant to figure it all out.

To learn more about the various types of retirement accounts, take a look at our breakdown of the best options: An Introduction to Tax-Advantaged Retirement Accounts

The post Roth vs. Traditional Retirement Accounts: What’s the Difference? appeared first on FinMasters.

A good retirement plan can be the difference between a relaxing retirement or having to work through your twilight years, so you’ll need to understand these distinctions and consider them carefully. We’ll tell you everything you need to know.

What is a Defined Benefit Plan?

A defined benefit retirement plan is one where the plan outlines the benefits that you’ll receive based on factors such as your earnings, how long you work, and the age at which you retire. In other words, the benefit that you receive when you retire is defined and lined out in the plan documents.

Under a defined benefit program, you don’t have to worry about investing your retirement savings or managing your portfolio. Instead, the organization offering the plan deals with that on your behalf.

Typically, defined benefit plans give retirees two options: a one-time payment when they retire or at a certain age or a regular income from their retirement until they die.

Pensions have grown rare in recent years, but Social Security is quite similar to a defined benefit plan and applies to the vast majority of Americans.

Under Social Security, Americans and their employers pay Social Security taxes. Based on the age at which you start taking benefits and your lifetime earnings, you receive regular Social Security payments from the government until you die.

Defined Benefit Plan Pros and Cons

What is a Defined Contribution Plan?

A defined contribution is one where the amount of money added to the plan is defined, but there is no guarantee as to how that money will grow or the retirement income it will produce.

With defined contribution plans, you are responsible for deciding how much to contribute to your retirement. You’re also responsible for deciding how that money should be invested. However, when you retire, you have full control over the money in the account and can withdraw it at whatever rate you’d like instead of having to wait for monthly payments.

For people looking for a defined contribution plan that’s not provided by an employer, an Individual Retirement Account (IRA) is a good option.

Both 401(k)s and IRAs may be available in traditional and Roth variants. These offer two different types of tax benefits. It’s important to understand the differences between traditional and Roth accounts and consider the benefits of having both types.

Defined Contribution Plan Pros and Cons

Defined Benefit vs. Defined Contribution: Which Is Better For You?

The reality is that defined benefit plans are going the way of the dinosaur. According to the Pension Rights Center, only about 31% of Americans have a pension plan from their employer. Unless you work in a few specific industries or for a government, odds are good that you won’t have much of a choice and will have to go with a defined contribution plan.

In general, defined contribution plans work well for people who earn higher amounts and who are good at saving and investing. If you have enough income to save and the discipline to invest well, you could turn a $500 a month retirement contribution into more than $1.5 million over the course of a 40-year career assuming 8% annual returns. That would be enough to support a retirement income of $60,000 or more, which would be a very generous income for a pension.

On the other hand, pensions are great for people who like simplicity. There’s not much simpler than just working for one employer throughout your career, retiring, and still seeing a paycheck come through each month. However, pensions give you less flexibility during and after your career and may give you less income than a well-managed defined contribution plan.

The good news is that most Americans can benefit from both. You’ll likely have access to a 401(k) from your employer and can always open an IRA. Additionally, Social Security will provide most people with a guaranteed retirement income much as a defined contribution plan would.

The post Defined Benefit vs. Defined Contribution: Understanding the Differences appeared first on FinMasters.

There’s a wide range of tax-advantaged accounts out there, but many of them are only viable for specific groups of people or types of expenses. Not all of them are an option for your long-term nest egg. Let’s look at some of the best options and some reasons why you might consider them.

In this post:

• Why Wouldn’t You Use a 401(k)?
• 401(k) Alternatives for Employees
• 401(k) Alternatives for Self-Employed Workers (Without Employees)
• 401(k) Alternatives for Small Business Owners With Employees
• 401(k) Alternatives for Federal Employees
• 401(k) Alternatives for Non-Profits

Why Wouldn’t You Use a 401(k)?

401(k) plans have replaced pensions as America’s most popular retirement plan. They now feature heavily in retirement strategies recommended by financial advisors.

401(k) plans have advantages, but they are not perfect. They tend to have higher fees and fewer investment options than other retirement accounts. Because they’re employer-sponsored plans, they frequently have strict vesting schedules that determine how long you have to stay with a company to claim your employer’s matching contribution (if any) and your investment gains. That means that leaving a job too soon can cost you your asset growth and company match. If the terms of your employer’s 401(k) plan aren’t attractive, you may choose not to participate.

Many people simply don’t have access to a 401(k) plan. Their employer may not offer one, or they may work for themselves. Fortunately, there are plenty of 401(k) alternatives out there for people who need them.

These are some of the most popular and practical alternatives to a 401(k). Review their features and see what would work best for you!

All the following 401(k) alternatives are tax-deferred, defined contribution plans. That means that any investment returns within the account are tax-free until withdrawal, and there are restrictions on the cash that comes in and out.

401(k) Alternatives for Employees

Individual Retirement Accounts

Individual Retirement Accounts (IRAs) are like miniature 401(k) plans, and they come in both traditional and Roth versions. That means you can choose to pay taxes when you take withdrawals (traditional) or when you make contributions (Roth). You can have more than one IRA at once, so it’s within the rules to have both a traditional and a Roth account.

Benefits: IRAs offer more flexibility than 401(k)s. They’re completely independent of employment status, so there are no vesting requirements. Actively earning income is generally the only requirement to contribute. They tend to have lower fees than 401(k)s, and you have complete discretion over what you invest in. You can buy mutual funds, index funds, individual stocks, and even real estate in some cases. 

Drawbacks: IRAs have lower contribution limits than 401(k)s. You can only contribute $6,000 a year ($7,000 if you’re over 50) in total to all your IRAs combined. That limit applies to both Traditional and Roth accounts, so if you wanted to maximize both, you could only put $3,000 into each. Different providers offer very different investment options, so you’ll need to shop carefully before selecting a provider.

When looking into an IRA as an alternative to a 401(k), it’s helpful to know how both of these accounts work, how they’re similar and how they are different: 401(k) vs. IRA.

401(k) Alternatives for Self-Employed Workers (Without Employees)

Solo 401(k)

Self-employed workers don’t have a boss who can offer them a 401(k), but they can start one for themselves. Even those who earn only a small income from a side hustle can qualify, as long as they have no employees of their own.

Because Solo 401(k)s are for a single person, they have lower fees than regular 401(k)s, more investment options, and no vesting schedule. In most other respects, 401(k)s function identically to the employer-sponsored version, except for their contributions.

Benefits: The most significant advantage of a Solo 401(k) is that it allows self-employed people to contribute to their accounts as both employee and employer. They can contribute their entire income up to $19,500 as an employee and 25% of their income subject to self-employment tax as an employer. The employer contribution limit is complicated, but it generally works out to about 20% of business income.

The two together must be less than $57,000, but employees over 50 can contribute an extra $6,500 for a whopping $63,500 total contribution limit.

Drawbacks: The only downside to a Solo 401(k) is the requirement that there can be only one member of the plan. Self-employed people who start their businesses and 401(k) without employees (or with their spouse) will run into issues if they ever try to hire people. If that’s something you expect to happen at any point in your business, look to the next option instead.

SEP IRAs

SEP IRA stands for Simplified Employee Pension Individual Retirement Account. It’s a defined contribution plan, just like the rest on this list, but it works a little differently than the others.

Employees can’t make contributions to their SEP IRA. Self-employed people can only contribute to their SEP IRAs through their capacity as an employer, and the limit is the same as it is for a Solo 401(k): 25% of earnings subject to self-employment tax up to $57,000 (25% of compensation for other employees of the business).

Benefits: Usually, the only reason to go with a SEP IRA over a Solo 401k as a self-employed person is to allow future employees to join the plan. If you would like to preserve the option to hire sometime down the line, it might be worth choosing the SEP IRA.

Drawbacks: SEP IRAs are useful 401(k) alternatives for self-employed people who might eventually hire employees, but they can’t compete with the tax deduction of a 401(k). If you do end up hiring, you’ll need to keep the contribution percentage equal for all employees, including yourself.

401(k) Alternatives: 6 Best Options to Consider

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401(k) Alternatives for Small Business Owners With Employees

SIMPLE IRAs

SIMPLE (Savings Incentive Match Plan for Employees) IRAs are another 401(k) alternative for self-employed small business owners who have employees.

Employees and employers can both contribute to the plan. Employers have two options for their contributions. They can either:

• Match the employee contributions up to 3% of their salary or $5,600.
• Contribute 2% of the employee’s compensation, regardless of the employee’s contributions.

Employees can contribute up to $13,500 each year, and those over 50 can put in an extra $3,000.

Are your retirement savings falling short? Here are some great ways to catch up: 11 Easy Money-Saving Tips for Seniors

Benefits: SIMPLE IRAs offer many of the same benefits that regular IRAs do, but they have larger contribution limits. For those choosing between a SIMPLE and SEP IRA, the primary advantage with a Simple IRA is the increased flexibility for employees. They have control of their contributions to a Simple IRA but can’t contribute at all with a SEP IRA.

Drawbacks: If there’s a disadvantage to Simple IRAs, it’s for the employers. Under a SIMPLE IRA, they have to make contributions on their employees’ behalf no matter what. Under a SEP IRA, employers can choose not to make contributions if they don’t want to in any given year.

401(k) Alternatives for Federal Employees

Thrift Savings Plans

Thrift Savings Plans (TSPs) are the equivalent of a 401(k) for employees of the federal government. They function virtually identically to 401(k) plans, and even the contribution limits are the same: $19,500 per year with an additional $6,500 for people over 50.

Benefits: While the primary benefit of a TSP is that it’s accessible to federal employees who can’t get 401(k)s, there are a few other bonuses. 401(k)s tend to have higher fees than other retirement accounts, but TSPs don’t have that issue. They even have cheaper investment options, including low-cost index funds. Finally, the federal government automatically contributes 1% of each federal employee’s salary to their TSP, but they’ll match up to 5%.

Drawbacks: Only federal employees can access TSPs, so they’re not a viable option for anyone else.

401(k) Alternatives for Non-Profits

403(b) Plans

403(b) plans are the equivalent of a 401(k) for people that work at non-profit companies. They function just like 401(k)s and TSPs, including the contribution limit and catch up bonus for contributors over age 50. 

Benefits: 403(b) plans allow employees of public schools and charities to contribute large portions of their salary to a tax-deferred retirement account. They have all the same benefits as a regular 401(k).

Drawbacks: The only downside to a 403(b) plan is that they tend to have lower employer matches than 401(k)s and TSPs. Non-profits usually don’t have as much extra cash to give their employees additional compensation.

Consider Getting Expert Help

This is a brief summary of the rules and regulations for most of these 401(k) alternatives. Many of them have complex rules that exceed the scope of this article. Make sure to study the requirements and restrictions of a plan before investing in it, especially if you want to use more than one at a time.

It’s always best practice to consult a financial expert before committing to a significant financial decision. Talk to a financial advisor or a Certified Public Accountant to find out what makes the most sense for your situation.

Looking to save extra money for retirement? Here are some great ways to get started: Saving Money 101

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