According to the Tax Policy Center, 60 million Americans pay into an Individual Retirement Account. This means that millions of Americans understand the benefit of paying into a tax-deferred account that only serves to help them grow their wealth over time.
Not even thinking about retirement yet? Building wealth is an issue that, for many, is considered a priority no matter how old you are. When it’s time for you to finally retire, you’ll be grateful that you invested in your retirement fund while you had the chance.
Whether you’re in your 30s or your 50s, you’re likely always experiencing some sort of “new” stage of life that includes changes in your family life, personal life, and your finances. Prepare for the leap from working to retiring well in advance by putting money away in an investment account. Here’s how it can help you build wealth.
What Are the Different Types of Retirement Accounts?
Let’s dive first into the different types of retirement accounts to help you better understand what your options are in terms of wealth-building in this way.
Traditional IRAs
At-a-Glance: Traditional IRAs come with a set of restrictions, including how much you can contribute and when you can start withdrawing without penalty. These accounts are basically a wager on the tax rate that you will cancel when you start making withdrawals after age 59½ since the accounts grow tax-deferred but are taxed on withdrawal.
Traditional IRAs aren’t the kinds of IRAs that you enroll in through an employer (like a 401(k), for example). With traditional IRAs, you’re depositing money into the account in a tax-deferred way. This means that you don’t have to pay taxes on any of the money in that account. At least, not until you retire and begin to withdraw.
The contribution limit for a traditional IRA in 2020-2021 is $6,000 for those under the age of 50 and $7,000 for people over 50 years of age. Because it’s a tax-deferred account, a traditional IRA is a great option for those who want to reduce their tax bill in the immediate future (however, do keep in mind that you’ll eventually be taxed on some of that cash).
Now, keep in mind that this is only going to reduce your tax bill if you end up owing more than the contribution limit (i.e., it mostly benefits those with higher incomes).
Roth IRAs
At-a-Glance: Roth IRAs are private retirement accounts that can be opened and financed by you (not your employer). Roth IRA contributions are made with money after paying taxes, which means that your money grows tax-free. This is different from a traditional IRA in that Roth IRAs allow you to make tax-free withdrawals after about 59½ (because you’ve already been taxed on the money that’s in the account).
The biggest difference between a traditional IRA and a Roth IRA is that Roth IRA contributions are made with money after taxes. For those looking to start saving immediately, the current contribution limit is $6,000 in 2020-2021 and $7,000 for people over 50 years of age.
Contributing to a Roth IRA doesn’t reduce your tax bill at present. But it’s a great option for investing in your future. And it can help you grow your money long-term. As well, due to the tax-free withdrawals in the future, you’ll find that when you’re ready to retire, you can better calculate exactly how much money you’ll be getting without having to think about how much they’ll take out for taxes (depending on when you start to withdraw).
Roth IRAs, in short, are best for people looking to enjoy tax-free withdrawals during retirement. They’re also a great option for those currently in a low-income tax bracket and aspire to be in a higher income tax bracket later. High-income earners won’t benefit much from a Roth IRA as the income limit to be able to make contributions is $140,000 in 2021.
401(k)
At-a-Glance: Different than IRAs, which stand for individual retirement accounts, a 401(k) is an employer-sponsored retirement account. As an employee, this means that you’re able to allocate a percentage of your pre-tax salary to a retirement account.
Often, a 401(k) is a great option for those looking to build their wealth quickly. Why? Most employers offer contribution matching programs where they’ll match your yearly contribution. This, obviously, equals free cash for you!
However, these types of retirement accounts are similar to traditional IRAs. When you contribute, your money is going into the account tax-free while you pay taxes on the employer matching contribution. When you reach retirement and decide to start withdrawing, you’ll pay taxes on those withdrawals.
401(k)s are a great option for those looking to enjoy the benefits of employer matching as well as higher contribution limits. The contribution limit for a 401(k) in 2020 and 2021 is $19,500 if you’re under the age of 50 and $26,000 for those 50 or older.
How Do Retirement Accounts Help Build Wealth?
The National Study of Millionaires found that 3 out of 4 millionaires (75%) said that regular, consistent investing over a long period of time is the reason for their success. One of the easiest ways to engage in consistent investing is to invest in a retirement account.
The goal once you reach your 30s is to save 15% of your gross household income for retirement. Of course, you can start this earlier if you'd like.
This means that if your employer offers a 401(k) matching option, you should be maxing out your contributions. This will allow you to receive what is basically free money from your employer. For example, let's say you contribute $5,000 a year and they offer a 100% matching. That means that you’ll get $5,000 of free cash added into your account each year.
For those of you still struggling to understand how the accounts mentioned above help you build wealth, here’s a breakdown of a real-world example.
Example of 401(k) Growth
For this example, we’ll talk about the employer maximum. That's the maximum percentage of your salary that an employer will match. Usually, this goes up to about 6%.
So, let’s say that your employer offers you a 50% match at a maximum of 6% of your salary. This means that if you earn $40,000 a year, their absolute maximum contribution would be $2,400.
But, let’s say that you, too, want to contribute just 6%. You’d be putting $2,400 away into your retirement account. Assuming still that your employer is offering a 50% match, it means that they’ll add $1,200 into your account too! You’ve just earned $1,200 of practically free cash.
Build Wealth with WealthStack
Saving for retirement, a large purchase, or a brand new home? Saving is a crucial tool to master when building a strong financial future. Investing in your savings further compounds your wealth. But if you’re new to that or feel unsure of how to best invest your hard-earned cash, you’re in the right place!
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