Investing

Building a Nestegg With Retirement Accounts

Depending on your situation, there are many ways to build a nestegg for retirement. Regular employees in both the private and public sectors as well as self-employed individuals can choose to save in a 401(k), Roth 401(k), Traditional IRA, Roth IRA, 403(b) (schools, certain non-profits, and tax-exempt organizations), 457(b) (state and local governments), pension plan, Thrift Savings Plan (TSP) (federal government), or even a Health Savings Account (HSA).

 

401(k)

Benefits of Employer-Sponsored 401(k) Plans

• Tax Advantages - Contributions to a traditional 401(k) are made pre-tax, reducing your taxable income for the year. Roth 401(k) options allow after-tax contributions, with qualified withdrawals being tax-free.
• Employer Matching Contributions - Many employers match a percentage of employee contributions, effectively providing free money to boost your retirement savings.
• Higher Contribution Limits - For 2024, the annual contribution limit is $23,000, with an additional $7,500 catch-up contribution for individuals aged 50 and older.
• Automatic Payroll Deductions - Contributions are conveniently deducted from your paycheck, encouraging consistent saving without the need for manual transfers.
• Investment Options - Employer-sponsored 401(k)s offer a range of investment options, including mutual funds, target-date funds, and index funds, allowing participants to tailor investments to their risk tolerance and time horizon.

Limitations of Employer-Sponsored 401(k) Plans

• Limited Investment Choices - The plan administrator determines the available investment options, which may not include all asset classes or preferred funds.
• Fees and Expenses - Some plans charge high administrative or fund management fees, which can erode long-term gains.
• Required Minimum Distributions (RMDs) - Starting at age 73 (as of 2024), account holders must begin taking RMDs, potentially depleting savings more quickly and increasing taxable income.
• Contribution Caps - Despite higher limits compared to IRAs, contributions are capped annually, which may not suffice for individuals looking to save aggressively.
• Early Withdrawal Penalties - Withdrawals before age 59½ are subject to a 10% penalty and income tax unless exceptions apply.

Benefits of Solo 401(k) Plans

• Dual Contribution Roles - As both employer and employee, you can contribute up to $23,000 as the employee (2024 limit) and up to 25% of your business’s net income as the employer, with a combined limit of $69,000 (or $76,500 with catch-up contributions for those aged 50+).
• Tax Advantages - Traditional solo 401(k)s allow pre-tax contributions, reducing taxable income. Roth solo 401(k)s offer tax-free growth and withdrawals.
• Broad Investment Options - Solo 401(k)s often provide greater flexibility in investment choices, including stocks, bonds, mutual funds, and even real estate in some cases.
• Loan Options - Many solo 401(k) plans allow participants to borrow up to 50% of their account balance, up to a maximum of $50,000, for personal use.
• Exclusivity for the Self-Employed - Designed for sole proprietors or business owners without employees, these plans are tailored to maximize retirement savings for small business owners.

Limitations of Solo 401(k) Plans

• Eligibility Restrictions - Solo 401(k)s are only available to self-employed individuals or business owners without employees (except for a spouse).
• Administrative Responsibilities - Once assets exceed $250,000, the IRS requires annual filing of Form 5500-EZ, adding administrative complexity.
• Required Minimum Distributions (RMDs) - Starting at age 73 (as of 2024), account holders must begin taking RMDs, potentially depleting savings more quickly and increasing taxable income.
• Contribution Caps - While higher than employer-sponsored plans, contribution limits can still be restrictive for high-income earners.
• Early Withdrawal Penalties - Similar to traditional 401(k)s, early withdrawals are subject to penalties and taxes unless specific conditions are met.

IRA

Benefits of Traditional IRAs

• Tax-Deferred Growth - Contributions to a traditional IRA are made pre-tax, which reduces your taxable income for the year. Investments grow tax-deferred, meaning you won’t pay taxes on gains until you withdraw funds in retirement.
• Eligibility Across Income Levels - Unlike Roth IRAs, traditional IRAs don’t have income limits for making contributions, although tax deductibility may be limited based on income and participation in an employer-sponsored retirement plan.
• Wide Investment Options - Traditional IRAs allow you to invest in a broad range of assets, including stocks, bonds, mutual funds, and ETFs, giving you flexibility to tailor your portfolio to your financial goals and risk tolerance.
• Catch-Up Contributions - Individuals aged 50 and older can contribute an additional $1,000 annually, boosting retirement savings during peak earning years.

Limitations of Traditional IRAs

• Taxable Withdrawals - Withdrawals in retirement are taxed as ordinary income, which may be a disadvantage if your retirement tax bracket is high. This tax is on both the original contribution and any capital gains as ordinary income.
• Required Minimum Distributions (RMDs) - Starting at age 73 (as of 2024), account holders must begin taking RMDs, potentially depleting savings more quickly and increasing taxable income.
• Contribution Limits - The annual contribution limit for 2024 is $7,000 ($8,000 for those aged 50+), which applies to single filers with a modified adjusted gross income (MAGI) under $146,000 and married (joint) filers with MAGI under $230,000. This may not be sufficient for aggressive savers.
• Early Withdrawal Penalties - Withdrawals before age 59½ are subject to a 10% penalty and income tax unless exceptions apply.

Benefits of Roth IRAs

• Tax-Free Growth and Withdrawals - Contributions are made with after-tax dollars, but qualified withdrawals in retirement—including earnings—are completely tax-free, providing significant tax advantages.
• No RMDs - Roth IRAs do not require account holders to take RMDs during their lifetime, allowing funds to grow tax-free for as long as desired.
• Flexible Withdrawal Rules - Contributions (not earnings) can be withdrawn at any time without penalties or taxes, offering liquidity in case of emergencies.
• Beneficial for Younger Investors - Younger individuals who expect to be in a higher tax bracket in retirement can benefit from paying taxes on contributions now, locking in tax-free income later.

Limitations of Roth IRAs

• Income Limits - High earners may be restricted from directly contributing to a Roth IRA. For 2024, eligibility phases out for individuals earning over $146,000 (single) or $230,000 (married filing jointly).
• After-Tax Contributions - Contributions are not tax-deductible, which may be less advantageous for those seeking immediate tax relief.
• Contribution Limits - The annual contribution limit for 2024 is $7,000 ($8,000 for those aged 50+), which applies to single filers with a modified adjusted gross income (MAGI) under $146,000 and married (joint) filers with MAGI under $230,000. This may not be sufficient for aggressive savers.
• Early Withdrawal Penalties - Withdrawals of earnings before age 59½ and before the account has been open for five years may incur taxes and penalties. this is known as the 5 year rule and has several exceptions.

 

403(b), 457(b), and TSP

Both the 403(b) and 457(b) are similar to a 401(k) in that they are taxed deferred, can roll over into an IRA, and have similar stipulations and contribution limits. However, the 403(b) is generally offered by non-profit entities and allows an extra $3,000 per year in contributions if you have a tenure of 15 years over which you have contributed on average $5,000 or less per year. The 457(b) has different stipulations for governmental vs. non-governmental plans. You will need to understand these stipulations to determine if they are still an attractive option.

The Thrift Savings Plan (TSP) for federal government employees was modeled on the 401(k) and there are Roth versions. The TSP tends to have more limited investment options than the typical 401(k) but also tends to have lower fees. The TSP provides a 1% employer contribution and matches up to 4% for up to 5% in employer contributions, which is superior to most 401(k) plans. Federal employees can learn more about their benefits here https://www.opm.gov/retirement-center/.

 

Pension Plans

A pension plan, also known as a defined benefit plan, is a retirement program provided by employers that guarantees a fixed income to employees after retirement. Some government entities still offer pensions although they are becoming increasing less common. In most pension plans, the employer contributes to a pooled fund on behalf of employees. Contributions are typically based on factors like employee salaries, tenure, and actuarial calculations. Some plans require employees to contribute a portion of their salary, which is often deducted automatically from paychecks and may be tax-deferred. Pension benefits are accrued based on a formula determined by the plan often including factors such as years of service, salary and a multiplier. Retirees receive a steady income, typically paid monthly, for the rest of their lives. Plans often allow for survivor benefits, which provide a portion of the pension to a spouse or beneficiary after the retiree's death. Some plans include cost-of-living adjustments (COLAs) to account for inflation. Eligibility for full benefits is often determined by a vesting period.

 

Heath Savings Account (HSA)

A HSA is typically known for its role in helping individuals save for medical expenses, but it can also serve as a powerful retirement investment tool. HSAs are one of the most tax-advantaged accounts available, offering three distinct benefits that make them ideal for long-term savings, including retirement: tax-free contributions, tax-free growth, and tax-free distributions. Once your HSA balance exceeds a certain threshold determined by the provider, you can invest the funds in options such as mutual funds, ETFs, and other securities, similar to a 401(k) or IRA. This allows your contributions to grow over time. After age 65, you can use HSA funds tax-free for qualified medical expenses; Medicare Part B, Part D, and Medicare Advantage premiums; and also some long-term care costs or insurance premiums. After age 65, you can use HSA funds for non-medical expenses without a 20% penalty. However, these withdrawals are subject to ordinary income tax, similar to a traditional IRA. Unlike traditional 401(k)s or IRAs, HSAs do not require you to take RMDs, allowing your savings to grow tax-free indefinitely. Maximizing your HSA contributions ($8,300 for family in 2024 including employer contributions) can help you build a nestegg for your retirement.

Building a Nestegg With Investments

Traditional investments such as stocks, bonds, mutual funds, ETFs, and real estate can help supplement those made through retirement accounts. These can be very helpful in planning an early retirement and avoiding a larger tax bill with tax deferred account withdrawals.

 

Mixed Portfolio Strategies

Creating a mixed portfolio of stocks and bonds tailored for retirement requires balancing growth potential with risk management to ensure your investments meet your retirement goals. A common mistake made by many who see themselves as risk adverse is to focus too much on a single low risk asset class, such as bonds, without realizing the real risk of inflation over a long life. Retirement shouldn't be spent planning for death but the future you have left. Stocks provide growth potential, bonds offer stability, and other asset classes provide a mix of both. Stocks require a fair amount of attention and rebalancing to ensure you are investing in value for the long term. One way to achieve diversification of stocks is by purchasing ETFs that represent a specific sector or even the broader market itself.

 

ETFs (Exchange Traded Funds)

ETFs are a type of investment vehicle that allows you to access a pool of assets through a single security. They are a good choice for those who want to invest in a diversified portfolio without the need to buy individual stocks or bonds. ETFs can be more stable and less volatile than individual stocks, making them suitable for long-term investment. Popular ETFs include S&P 500, Dow Jones, Nasdaq, and Russell 2000 that track the performance of the stock market. The stocks comprising these indexes change over time, but their overall performance is relatively stable since they tend to represent a broad range of companies. This makes account growth over many years more predictable.

 

Passive Income Through Real Estate

There are several benefits to investing in real estate to generate passive income. Rental properties can generate a relatively consistent monthly cash flow, providing a supplement to Social Security and other retirement savings. This income stream also generally tracks inflation as rental rates increase thus preserving purchasing power over time. Real estate often increases in value over the long term, potentially boosting your net worth and providing equity to tap into if needed. Investing in real estate reduces reliance on traditional financial markets and furtherdiversifies your income sources.

There are some challenges as well such as a high initial investment and ongoing maintenance costs. Costs can include property taxes, repairs, and property management fees which all must be factored into your budget to achieve profitability. Also, real estate is a volatile investment and can be subject to market fluctuations. This can complicate what is already an illiquid asset. Finally, dealing with day to day issues can become a challenge as one gets older even with the help of a property management company.

NEXT TOPIC