Become a better investor
Lesson in Course: Finance at work (advanced, 5min )
Retirement accounts have some great benefits, but are there strings attached?
Retirement accounts are excellent for long-term investing; however, they have rules that we need to keep in mind.
There are limits to how much money we can put into these accounts each year. The IRS sets contribution limits each year, making slight increases annually for cost-of-living adjustments.
For employer-sponsored plans, there are two limits. One is the maximum amount that we can contribute from our salary. The other is a limit on the combined amount by our employer and us if our employer matches contributions.
How much we can put into our IRA is much lower than the limits on retirement accounts through our employer. That said, they are independent of one another, so contributions to our 401(k) wouldn't count toward the limit on our IRA.
In typical "when you're old enough" fashion, the IRS increases the limits for folks over a certain age to make additional "catch-up" contributions.
Outside of a few exceptions, the cash in these accounts is only accessible during our retirement years. Taking money out before retirement (before 59.5 years old) will result in paying a tax penalty of 10% in addition to any ordinary income tax we owe.
After we've turned 59.5 years old, the money in the account is available to be withdrawn without penalty. We'll have to pay income taxes when we take money out of Traditional retirement accounts since we put money in pre-tax. However, the income tax rate we pay might be lower when we take the money out in retirement than when we earned it.
Traditional retirement accounts don't allow us to keep money in there indefinitely. When we turn 70.5 years old, the IRS will expect us to start taking money out annually in regular periodic distributions. These are known as required minimum distributions.
We can easily determine our required minimum distribution by spreading the total account value amount over our life expectancy. For example, let's say we're 70 with an account amount with $500,000 in it. According to the IRS, our distribution period is 27.4, so our required minimum distribution would be about $18,500.
These limitations are in place so that we don't abuse the benefits of retirement accounts; however, they usually don't get in the way of reaching our retirement goals.
The biggest problem we want to avoid is putting money into a retirement account that we'll need to take out early. Remember, this results in paying a tax penalty.
Preventing this requires balancing our short-term and long-term needs. One way to do this is by contributing smaller amounts throughout the year, then maxing out with extra cash at the end of the year.
When we turn 70.5 years old, the IRS expects us to start taking at least a minimum amount of money from our retirement accounts every year depending on how old we are and how much is in the account.