How Do Retirement Funds Work?
Retirement funds are accounts that you contribute money to for future use during retirement that are tax-advantaged to help your money grow more over time.
When you’re looking into retirement funds, you’re thinking about ways to stash your money away for the future to fund your retirement. Although retirement can take many different forms these days — ranging from maintaining some level of work to relaxing on a beach somewhere — having a nest egg when you get to retirement age will really open up your options.
Let’s take a look at what retirement funds are and how some of the different kinds of funds work.
Retirement funds work by benefiting from tax breaks from the IRS and other unique bonuses that incentivize you to stash away money for retirement. In general, traditional accounts give you a tax break now, while Roth retirement funds allow you to withdraw the money during retirement tax-free.
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What is a Retirement Fund?
A retirement fund, also commonly called a retirement plan or retirement account, is a method that you can use to set aside money for the long term that you will use when you retire later in life. Retirement funds vary drastically from a typical savings account or a regular taxable brokerage account that you may have, but they were created to benefit you in the long run.
Unlike most other financial accounts that you might have, retirement funds have a slew of benefits — and limits — that you need to keep in mind while you’re planning for retirement. We’ll go into a bit more detail on each type of retirement fund below, but the main reason that you want to set up a retirement fund is because of the substantial benefits (i.e. matching, tax benefits, etc.) that they provide for you. So adding some sort of retirement fund to your financial plan can have a big effect on your financial stability later in life.
What Types of Retirement Funds Are There?
As you start working towards planning your retirement, you might start to see a whole bunch of different options out there that you can start funding for your future retirement. There is no clear answer on which one is best or which one(s) you can even use, as that will change based on your personal situation. Although not an all-inclusive list, some of the different retirement funds out there that you will see include:
- Traditional IRA
- Roth IRA
- Roth 401(k)
- Thrift Savings Plan (TSP)
- SEP IRA
Again, there are more retirement funds out there, but these are some of the most common. Let’s take a look at the funds that most people will consider or have access to and get an idea of how they work.
How Does a 401k Work?
Far and away the most common type of retirement fund across the country is the 401(k). A 401(k) is an employer-sponsored retirement plan that you, as an employee can contribute part of your salary or wages to. The major benefit of a 401(k) retirement fund is that they are tax-favored and tax-sheltered, so you get to take advantage of these benefits while you’re working and also long after retirement.
Most companies that offer a retirement plan to their employees offer a traditional 401(k). In this type of 401(k), you contribute to the account with pre-tax dollars. This means you can deduct your contributions from your taxable income and catch a tax break now. But later in life when you retire and go to start withdrawing from the account, you’ll pay taxes on everything that you take out of the account.
A less common option that employers might offer is a Roth 401(k), but they are seen far less. There will be more info on Roth accounts in general later on while discussing Roth IRAs, but it’s important to know the difference in 401(k) options. With a Roth 401(k), you fund the account with after-tax dollars. This means you pay taxes on the contributions now so that in retirement, the money from your contributions and all of the earnings tied to those contributions are tax-free.
No matter which type of 401(k) a company offers, one of the major additional benefits outside of the tax breaks is the 401(k) match that many employers provide. A 401(k) match is when a company offers to match their employee’s 401(k) contributions — or at least a portion of them — up to a certain percentage of the employee’s salary. This is usually around 5% or so, but that’s a lot of money over time and a guaranteed return on your contributions.
One thing to keep in mind is that 401(k) matches are always treated as if they are in a traditional 401(k), even if the employee has a Roth 401(k). Since the employee match is not money that has been taxed, it cannot be included in the Roth portion of the account. So if you have a Roth 401(k) and receive a company match, the matched portion will be treated as traditional and be taxed in retirement.
As a tax-advantaged account, the IRS defines limits as to what can be contributed to a 401(k) retirement fund. As of 2021, the annual contribution limit is $19,500. This is increased to $26,000 per year if you’re 50 years old or older. Also, the total combined limit of your contribution and an employer’s match cannot exceed $58,000 per year.
If you’re currently employed and your employer offers a 401(k) and a 401(k) match, you should try to contribute enough to at least get the full amount possible from the match. If you’re able to contribute more, great! But always try to get as much “free money” from your employer’s 401(k) match as possible.
How Does an IRA Work?
You’ve seen the term a few times in this article already and are probably curious about what the acronym stands for, so you might be thinking What is an IRA? An IRA (whether it’s designated as traditional, Roth, SEP, etc.) is an Individual Retirement Account. This type of account is a tax-favored retirement fund that is yours and yours only, hence the term individual.
Within an IRA — which you can open with any of the major brokerages out there — you can invest in what you want, rather than just the options your employer might offer in their plan. You can choose to invest in stocks, exchange-traded funds (ETFs), mutual funds, bonds, and more. This gives you the freedom to control what you’re retirement is invested in.
When it comes to IRAs, you can contribute up to a maximum of $6,000 annually as of 2021. This is the combined total amount of all IRAs you have, not per account. If you’re over the age of 50, you can increase this to $7,000 as a way to catch up.
Within this type of retirement fund, you don’t have to pay annual income or capital gains taxes on any of your investment earnings within the account since the funds are tax-sheltered once they are inside the IRA, so you can buy and sell investments as you please. If you’re investing in an IRA because you don’t have an employer-sponsored retirement plan, your contributions may be tax-deductible in many cases. So you can see some of the early benefits that IRAs offer you.
Let’s go into a bit more detail on the two most common types of IRAs you will see.
What is a Traditional IRA?
If you don’t have access to an employee-sponsored retirement fund or you just want to have more investment options to choose from, a traditional IRA can be opened by anyone in the US. This is the most common type of IRA today, and it’s a retirement fund that acts much like the traditional 401(k) you read about above, without the addition of potential contribution matching from your employer.
In a traditional IRA, you make contributions to the fund with pre-tax dollars. This means that you can deduct your contributions from your gross income and save money on the taxes that you owe now. In a traditional IRA, once you contribute funds to it, that money is committed to the account, and if you make a withdrawal before you’re 59 ½ years old, you will be subject to pay an early withdrawal penalty as well as income taxes.
When you eventually withdraw the funds later in retirement (after age 59 ½), you will be required to pay income taxes on everything you take out — both your contributions and any earnings on your investments. So this type of IRA will save you money on taxes now, but you’ll owe the IRS later in life.
What is a Roth IRA?
The other most common type of IRA that you might have heard of is the Roth IRA. Similar to a traditional IRA, a Roth IRA is a retirement account that you can open yourself with any of the major brokerages out there. Anyone in the US can open a Roth IRA and start contributing funds to it towards their retirement, but there are a couple of restrictions that we’ll get to later.
With a Roth IRA, you fund the account with after-tax dollars. This is where the major differences between these two IRAs start to come in. Since you are funding it with after-tax dollars, you don’t get a tax deduction on your contributions now, but you get big tax benefits in the future. Also unlike a traditional IRA, you’re able to withdraw your contributions — not any earnings — at any time without paying a penalty or taxes, since you’ve already been taxed on that money.
Within a Roth IRA, after reaching age 59 ½ and having at least one Roth IRA open for 5 years or more, you are eligible to withdraw the money — penalty and tax-free. That’s right, in a Roth you pay zero in taxes on anything that you withdraw, including both your contributions and earnings. This is because you already paid taxes on the contributions, and the tax advantage of the Roth is that any earnings within the account can grow tax-free.
In a traditional IRA, no income limit bars you from contributing. In a Roth, however, you can only contribute the full annual limit if your modified adjusted gross income (MAGI) is below $125,000 for single filers or below $198,000 for those who are married and filing jointly. If your MAGI ranges from $125,000 to $140,000 ($198,000 to $208,000 for joint filers), you will be able to contribute a smaller amount to a Roth before phasing out above the top limit.
Will Social Security Fund My Retirement?
Social Security is a government-sponsored retirement fund that helps ensure retirees will not go broke after retirement. If you’ve ever looked at your paycheck and saw a deduction for OASDI (Old-Age, Survivors, and Disability Insurance), that’s your Social Security contribution. This is a system you’re automatically enrolled into at most jobs and one that you cannot opt-out of.
To qualify for Social Security, you need to be at least 62 years old — or meet one of the other requirements such as being disabled — and to have contributed to the system for 10 years. Social Security benefits are then paid to you monthly by the government in retirement. Once you start collecting Social Security benefits, you receive them for the remainder of your life.
Social Security benefits are calculated using your 35 highest-earning years, so the longer you work and the more you make, the higher your benefits will typically be. Up to a certain point. You will also receive higher benefits if you wait until your “full retirement age” (either 66 or 67 depending on when you were born) or until you’re 70.
Many people in America solely rely on Social Security to retire, and that isn’t really the best way to plan for your future. As of 2021, the maximum benefit someone can receive is $3,895 per month. To do this, you need to have 35 high-earning years of work, pay into Social Security for at least 10 years, and wait until age 70 to claim benefits. The typical Social Security payment is around $2,300 per month. That isn’t a very lavish life in retirement.
Also, keep in mind that there is no guarantee that Social Security will always be there when you reach retirement age. And if it is, there’s no telling what the benefits will actually look like at that point. That said, it isn’t recommended to only rely on Social Security to fund your retirement alone.
If you’re looking into your future and wanting to plan your retirement, it’s best to take a diversified approach in both your investments and the retirement funds that you choose to utilize. Take advantage of a 401(k), open an IRA on your own, and welcome any additional benefits you receive from Social Security. The earlier you start planning for retirement, the easier it is. But it’s never too late to get started!
About THE AUTHOR
With multiple family members currently in senior living facilities, David is in the trenches every week, learning the ins and outs of nursing homes, assisted living, memory care, and general senior living.Read more about David Bolton
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We love planning for retirement. It's somewhat of a hobby, and we want to share what we've learned with you. Over the years we've found the best ways to live, how to travel, take on new hobbies and give back. Happiness in retirement is the main goal, and having the right information allows us (and you) to achieve that.