If you take nothing else away from this article, remember the most important thing is to get started with retirement savings. Don't wait until you have a bigger pot of money or feel like you understand everything about investing or all the nuances of taxes (even the experts are always learning new things). Just get started: choose a plan to get you going and put some money in it. You can choose your investments, change things up, or start a new plan as you learn more. None of the options below are bad, so any of them that you're eligible for will help you get going.
Basic Concepts for Retirement Savings (at least as far as taxes go)
You could think of investment accounts like tupperware containers (just go with us on this for a second...), which come in lots of shapes and sizes. They're just places to hold onto your money, and hopefully it grows while it's in there (kinda like mold... ). And also like tupperware, it's totally okay, even pretty common, to have a small collection of different ones at the same time—some you use very regularly, some you rollover into a new container (let's call this switching lids), while others you use for awhile, don't touch for years, and then decide to go back to.
Each type of container has different pros and cons:
- A regular investment account doesn't have any particular benefits other than it allows you to invest in lots of different things, like stocks, bonds, mutual funds, and exchange traded funds, among other things. You'll pay taxes on the money you earn in an investment account as you earn it for every year that you're invested in something.
- A tax-benefit-now retirement account (also called a "tax deferred account") is pretty much the same as a regular investment account, you can generally invest in different kinds of things with the money in that account, but you don't have to pay taxes on the money you put in until after you retire (or reach the age when you're eligible for withdrawals).
- A tax-benefit-later retirement account is the opposite of the tax-deferred account: you pay taxes now on the money that you put into it so that you don't have to pay taxes when you start taking that money out (along with the earnings).
There are also retirement accounts called "defined benefit plans," which are less common these days. You may have heard them described simply as pensions. These are when the place you work for says they'll pay you a set amount every year after you retire. Usually you have to work for a place for a looong time to get the full benefit, and nowadays these plans typically only exist for government workers (public school teachers, police officers, civil servants, those in the military, etc). Since these plans involve less individual management of the account, we're not going to get into them here.
We're also not going to get into stock benefits (when an employer gives you shares of the company), because those are most often just a kind of investment and are not typically a type of retirement plan.
Why would I want to pay taxes now instead of later? This is confusing!
Ultimately, you're going to have to pay taxes at some point on the money you put into retirement. You're just trying to make your best guess about whether it would be better for you to pay the taxes now or later.
The general question to ask for tax purposes is: When do you think your income is going to be at its highest (that's when your tax bills will be highest)?
- If you think your tax bill is gonna be highest while you're working (i.e. you're going to be earning more money during your career), you might consider a tax-benefit-now plan to help bring your tax bill down.
- If you think your tax bill is going to be the same or higher in retirement (i.e. you're going to be earning the same amount or more in retirement), you might consider a tax-benefit-later plan.
- The other thing to consider is that if you're investing over a long period of time, the amount of money you earn from your investments can start to get pretty significant, and tax-benefit-later plans like a ROTH IRA can help you eliminate the tax bill on those earnings when you start to withdraw, which is a big benefit.
Some people keep both types of accounts and use them for different reasons at different times. Again, if you're just getting started, don't let the details weigh you down too much. Get started and try to learn more as you go. We do offer financial advising if you want some advice about your circumstances (just write to info@brasstaxes.com to get a consultation set up).
Common Types of Tax-Benefit-Now Accounts
The basic idea for these accounts is that the money you put in each year is taken out of your taxable income. Think of it this way: If you earn $48,000 in a year and put $8,000 into this type of a retirement account, the amount of money you pay taxes on that year will be reduced by $8,000.
- Traditional 401(k) - A retirement plan set up by your employer where they take part of your paycheck every pay period and put it into a retirement plan for you. Some employers will also match the amount you put in, or a portion of that amount.
- Deadline to make contributions: By the end of the calendar year.
- There are contribution limits for this kind of account.
- 403(b) - Pretty much exactly like a Traditional 401(k) except that they're offered by non-profits and some schools/universities.
- Traditional IRA - This is an account you can set up and manage yourself with most financial institutions that offer investment options.
- Deadline to make contributions: By the tax deadline (for example, 2023 contributions can be made up until April 15, 2024, or the extension deadline if you file for an extension).
- There are contribution limits for this kind of account.
- Solo 401(k) - Very similar to the Traditional 401(k) except that it's intended for self-employed people who are making a profit. There's a bit more work to set it up, but you can make both employer and employee contributions to this account. The math can get complicated on this (here's a good calculator) so make sure to talk with someone before setting this up to see if it's a good fit.
- Deadline to make contributions: By the end of the calendar year.
- SEP IRA - This is a unique kind of account for self-employed individuals that's really easy to set up and get started with, as long as you are making a profit in your freelance work.
- Deadline to make contributions: By the tax deadline (for example, 2023 contributions can be made up until April 15, 2024, or the extension deadline if you file for an extension).
- The trick here is that the maximum amount you can contribute each year is based on your profit for that year, so many of our clients wait until their tax appointment to figure out the right amount.
Common Types of Tax-Benefit-Later Accounts
The basic idea for these accounts is that you've already paid tax on the money you put in, so when you start taking the money out in the future, you won't have to pay taxes on those contributions or their earnings. Because those earnings are also tax-free, there are stricter limits around how much money can be put into these accounts, and overcontributions are common, so be mindful of the limits.
- ROTH IRA - This is an account you can set up and manage yourself with most financial institutions that offer investment options.
- Deadline to make contributions: By the tax deadline (for example, 2023 contributions can be made up until April 15, 2024, or the extension deadline if you file for an extension).
- There are contribution limits for this kind of account.
- ROTH 401(k) - Most often these are an option offered by your employer, though there are some financial institutions that will allow freelances to set up a ROTH Solo 401(k).
- Deadline to make contributions: By the end of the calendar year.
- There are contribution limits for this kind of account.
And remember, like those tupperware containers, you can have a drawer or cabinet full of different ones at the same time! You can have one or all of these accounts. You can have one that you contribute to for a couple years and never contribute to again. You can have a SEP IRA or Solo 401(k) for the years you're a freelancer (even if they aren't consecutive years) and a Traditional 401(k) for the years you work for a company, or both at the same time if you do both things at the same time. Choosing one doesn't mean you can't change things around or add on throughout your career.
Have more questions or want financial planning help? Write to info@brasstaxes.com to set up and consultation focused specifically on financial planning.