I get a lot of questions about which retirement accounts are the best for young adults, and what’s the difference between a traditional and rollover IRA? So, let’s explore the most common retirement accounts, including 401(k) and HSA accounts.
Basic Guide to the Different Types of Retirement Plans for Individuals
What is a 401(k) account?
More than 20% of Americans have a 401(k) meaning it’s one of the most popular retirement accounts. 401(k) are created by your employer and let you set aside part of each paycheck into the account, pre-tax. Pre-tax means the funds come out before you receive your pay and is deducted from your income for the year. You only pay taxes if you withdraw from the 401(k) plan.
The biggest perk is that employers often match your contributions, up to a certain percentage as part of their benefits package. So if you contribute $100, they also put in $100. Note: Some employers have a claw back provision if you leave the firm within a certain time frame. However, these matches substantially grow your plan and compound over time. For 2023, you are able to contribute up to $22,500 for the year, though most people are only contributing 3-5% of their annual pay. I would encourage you to contribute to the full amount of your employer’s matching plan.
For example, my prior employer matched 100% of the first 3% of contribution and then another 50% match, up to 5%, so I put in 5% of my annual salary and my employer matched 4%.
If you withdraw after ½ there's no tax penalty, but any withdrawals that occur before that may incur a 10% penalty of what you withdraw on top of regular income taxes. Overall, you should consider any funds placed in your 401(k) to be for long-term growth and not for immediate use.
I think I have a 403(b) and/or 457(b) ---
If you work for a nonprofit organization or government agency, then you likely have a 403(b) or 457(b). Like a 401(k), you contribute pre-tax earnings. Unlike the 401(k) and 403(b), the 457(b) lets you withdraw money penalty-free after you leave your job as long as you haven’t rolled in other retirement assets.
What’s a traditional IRA?
A traditional IRA is not sponsored by your employer like a 401(k), which means you can contribute directly up to the annual limit (2023 is $6,500). BONUS: If you make less than $68,000 or $109,000 married you can deduct your contribution from your federal income taxes, even if you are maxing out contributions on your 401(k). There are similar penalties to the 401(k) for withdrawing funds before 59½.
How does a Roth IRA work?
This one is different from the others as you contribute AFTER-tax dollars. You can’t deduct contributions from your taxes, but you don’t have to pay any capital gains or income taxes on the investment gains until you take distributions. However similar to traditional IRAs, withdrawing money before age 59½ may result in taxes and/or penalties. Additionally, a Roth IRA distribution is not subject to taxes provided it satisfies the IRS's 5-year aging rule.
It’s important to note that the IRS does set an income limit to be eligible to contribute to a Roth IRA (in 2023 it is $153,000 for single filers and $228,000 for married). There are some backdoor workarounds for this, but more on that at another time.
What’s the 411 on Rollover IRA?
Rollover IRAs, I’d argue, should be the most important to everyone (if they aren’t familiar, please keep reading). You use a rollover IRA when you leave a job in order to transfer your 401(k) or 403(b) from your previous employer. I recommend setting up a Rollover IRA at one of the brokerage houses – Schwab/TD Ameritrade or Fidelity are my favorites. You may be able to leave your money in the original plan, but I strongly encourage you to transfer it into a Rollover IRA so you can exercise full control of the investments. If you’re a Millennial, then you MAY have changed jobs a few times. 😊 If that’s the case, a Rollover IRA is perfect to keep all your retirement funds in one place—consolidated after each employment. Just make sure you fill out the paperwork correctly to avoid any tax consequence – funds should be transferred as a rollover, not a distribution.
Can I contribute to a rollover IRA?
Yes, you can contribute to a rollover IRA, up to $6,500 per year, and an additional $1,000 per year for those older than 55. If you mingle IRA contributions and rollover funds with your spouse into one account, it may be difficult to separate again. If your 401(k) plan is distributed to you via a check, you will only have 60 days from the date you receive it to deposit it into your rollover IRA account before being subject to withdrawal penalties from the IRS.
Once you set up a rollover IRA account, you can contact your former employer’s plan administrator, complete whatever necessary forms they request and ask for them to either cut a check to you directly (which would be an indirect rollover and must be deposited within 60 days) or to directly transfer the cash and/or assets (stocks, mutual funds) into the new IRA account.
What does an HSA cover?
Although your health care costs may be low now, they will likely be higher in retirement. So start planning now. An HSA can be a helpful tax-advantaged way to save for future costs and provides funds for any medical emergencies in the meantime. In order to open an HSA, you must have a high-deductible health plan. You and your employer can contribute pre-tax dollars, up to $3,850 for singles and $7,750 for family coverage per year. If you are 55 or older you can contribute an additional $1,000 as catch-up contributions. You can even invest your contributions. I have written a post providing details here. If the funds are used for qualified medical expenses, then the distributions won’t be taxed either. However, if you use the funds for other purposes, you may be hit with a 20% penalty and income taxes, but the penalty goes away after age 65 when only income taxes would apply.
Additional Retirement Tips
Saving for retirement is a process. Don’t wait another day or year to get started. Open a traditional IRA or get enrolled in your company’s 401(k). Make sure you maximize any employer matching program and stay invested! It doesn’t help to have funds sitting in cash in a retirement plan. If you have questions about the basics of investing, check out my 50/25/25 rule for investing 101.
Get started today and hope this provides a little more information on the most popular retirement options.
This is not an advertisement or solicitation for business, and my personal experience does not constitute universal application. Information is for informational and recreational purposes only. Each financial situation is unique, and you should do your own due diligence. Past performance does not guarantee future results. Some content may contain affiliate or referral links.
Jordan is the creator of Lifetime Tidbits and has spent more than 10 years working in finance, primarily as a securities trader. She holds her CFA charter and has been Series 7 & 63 licensed.