Tax-advantaged retirement accounts are designed to help you retire by providing tax benefits when you make contributions to your retirement accounts. However, these accounts have restrictions when it comes to how much you can contribute each year and at what age you can withdraw your money without penalty.
401(k) plans are usually offered by your employer and allow you to reduce the amount of tax you pay on your income. You contribute to your 401(k) from your salary before it is taxed so you don't pay taxes on your contributions until you retire. Your employer may also offer 401(k) matching which means that they will also contribute to your 401(k) account when you make a contribution. If your employer offers this, you definitely want to take advantage because it's free money.
In 2017, the maximum you can contribute to your 401(k) is $18k a year. If you are over the age of 50 you can also make additional catch-up contributions of $6k a year. Unlike IRAs (see below for more about IRAs), 401(k) plans have restrictions on the types of investments you can make. This will depend on the 401(k) plan your employer decides to use.
When you become 59 1/2 years old and want to withdraw money from your 401(k), you will pay taxes on your original contributions plus taxes on any investments gains. If you withdraw before you turn 59 1/2 then you will pay a 10% penalty on the withdrawal in addition to regular taxes which is why we would not recommend withdrawing early. There are exceptions that allow you to withdraw early without penalty such as using the money to buy your first house or to pay for medical expenses.
To simplify this further, we will give you an example: Say you make 60k a year and your employer offers a 401(k) with 50% matching. If you contribute $5k to your 401(k) your employer will match with 50% so you now have $7.5k in your account. You will also only pay taxes on 55k of income because your $5k contribution to your 401(k) is made pre-tax.
These are the accounts you want to contribute to if your employer does not have a 401(k) plan or your 401(k) plan does not come with any contribution matching.
You can make up to $5.5k a year (or $6.5k if you are 50 or older) combined in contributions to Roth or Traditional IRA accounts.Traditional IRA
Contributions to a traditional IRA are like ones to 401(k)s because they reduce the amount of tax you pay in the present by reducing your taxable income. Once you withdraw past the age of 59 1/2, you will need to pay tax on your original contributions plus tax on any investment gains. Like 401(k)s you will also pay a 10% penalty if you withdraw before you are 59 1/2.Roth IRA
Unlike traditional IRA contributions, contributions to Roth IRAs do not reduce your taxable income. However, they do give you greater flexibility with your money because you can withdraw your contributions before the age of 59 1/2 without penalty. Say you have $5k in your Roth IRA and after 1 year it grows to $6k through good investing. If you are older than 59 1/2 you can withdraw 6k and only pay taxes on the $1k gains since you already paid taxes on the $5k. If you withdraw $5k before turning 59 1/2, you will not need to pay a penalty but if you decide to withdraw the full $6k you will pay a 10% penalty and taxes on the $1k gains.
IRAs have greater flexibility than 401(k)s when it comes to the types of funds you can invest in. Most robo-advisors and stock brokers offer Roth and Traditional IRA accounts whereas 401(k)s are only offered through your employer.
These are similar to 401(k)s but for government, college/public school and non-profit employees. With 457 plans, you can withdraw before you turn 59 1/2 if you leave your current employer.
IRA accounts for owners and employees of small businesses that are similar to 401(k)s but have a few differences.