Navigating the ins and outs of retirement accounts

Some people can’t imagine their lives without their careers. Others have been ready for retirement since high school graduation.

No matter which camp you fall in, planning for retirement can help ensure your golden years live up to their name. It may sound daunting, but when you have an arsenal of accounts on your side — like 401(k)s and IRAs — you can equip yourself for the years ahead.

Why you might benefit from a retirement account

Aside from the obvious benefit of having a more robust bank account, here are some of the other common benefits associated with retirement accounts.

1. Compound interest

“Compound interest” is the interest accumulated on both your contributions and the interest those contributions have earned over time.

The sooner you start investing in your retirement accounts, the larger your financial benefits become over time from compound interest — with those benefits mostly being passive income, or extra money that you don’t have to actively work to accumulate.

2. Employer matches

If your retirement account is employer-sponsored, then you may also receive some sort of contribution match.

Say, for example, an employer offers a 50% match on contributions for up to 6% of an employee's salary. An employee earning $50,000 who contributes 6% annually ($3,000) would receive an additional $1,500 from their employer, bringing their total contribution to $4,500 for the year.

Conventional wisdom says to take advantage of employer-provided matching benefits you have available to you, but as always, only you know what’s right for your budget.

3. Grow strong saving habits along with your retirement funds

Habits can take a few months to form, but with practice, they become automatic. And with the help of automatic deposits and retirement elections, you can easily ensure you’re putting away money for your future each month.

Whatever you can afford to put away now will only grow with time, so do what you think is best for your current and future budget.

Understand your retirement account options

There are two main types of retirement accounts: 401(k)s and IRAs. Both accounts involve investing contributions into accounts like stocks and bonds. Sometimes this is done automatically, and other times you can select the accounts on your own.

The biggest difference between these accounts is that 401(k)s are typically sponsored by an employer, while IRAs are available independently.

Think of investing in these accounts like stashing money in a financial time capsule. You put your money in a safe place every month, lock it away to let it grow, then crack it open a few years down the line — typically when you’re at least 59 ½ years old.

Since you can have a 401(k) and an IRA at the same time, it helps to know the rules and regulations for each type of account.

1. 401(k)s

There are two kinds of 401(k)s: traditional and Roth. Both operate similarly by giving you a tax break upfront, but there are a few other significant differences to keep in mind.

Traditional 401(k)s

When you put money in a traditional 401(k) account, your contribution is deducted from your paycheck before taxes are taken out. This is called a pre-tax contribution and reduces your taxable income for the year.

The funds in your traditional 401(k) account grow tax-deferred, which means that you don't pay taxes on the growth until you withdraw the funds in retirement. The amount you’re taxed when you make your withdrawal will depend on whatever your income tax rate is at that time.

This type of tax advantage allows your money to grow faster over time, as you earn interest on the portion of your contributions that would have gone to taxes.

Roth 401(k)s

A Roth 401(k) is like a traditional 401(k), except with the inverse tax rules.

With a Roth 401(k), your contributions are made with after-tax dollars. This means that you don't get a tax break for contributing to the account as you do with a traditional 401(k), but you also don't have to pay taxes on the growth or when you withdraw the funds in retirement.

Overall, a Roth 401(k) can be a great option for people who expect to be in a higher tax bracket when they get to retirement, as well as for people who want to maximize their tax-free income in retirement.

2. Individual Retirement Accounts (IRAs)

An Individual Retirement Account, or IRA, isn’t available through an employer. Instead, it’s offered by banks, brokers, or other financial institutions.

A few other differences between a 401(k) and an IRA include:

Contribution limits: Typically, 401(k) contribution limits are significantly higher than IRAs.

Employer match: Since IRAs aren’t offered through employers, you won’t get any sort of match.

Investment options: With a 401(k), investment options are selected from a small pool. An IRA gives you the opportunity to pick and choose from a much broader range of options.

Otherwise, you’ll find that IRAs operate in the same way as 401(k)s, right down to offering traditional and Roth options.

Keep track of your accounts and make adjustments

Once your accounts are set up, they won’t require much maintenance unless you change jobs or need to adjust your contributions.

Here’s how you can make sure you’re staying on top of your money’s moves.

Set up and adjust contributions. Your employer or bank will get you set up with the paperwork needed to start your account. From there, you’ll pick how much you want to contribute each month, which will be automatically taken out of your paycheck or bank account.

Choose investments. Whether you pick a 401(k), an IRA, or both, you’ll need to choose how to invest your money. Most likely, you’ll be selecting from stocks, bonds, mutual funds, and exchange-traded funds. Your investment goals, risk tolerance, and timeline will influence how you spread your investments around.

Roll over accounts. You won’t lose your 401(k) when you change jobs, but you will need to decide whether you want to leave your money in the old account, roll it over into your new employer’s plan, or cash it out. If you leave it in your old account, you won’t be able to make additional contributions, and if you cash out, you may be subject to taxes and fees. If you roll your 401(k) into an IRA, you won’t have to deal with any penalties.

Monitor accounts. Think of checking up on your retirement accounts like getting an oil change for your car. You don’t have to do it all that often, but it’ll help your accounts run smoother when you do. Maybe you had a change in life circumstances, or maybe a particular stock isn’t performing well — either way, you can finetune your account whenever needed.

Consult a certified financial advisor. Feeling confused or overwhelmed by some or all of this info? You aren’t alone — that’s why there are financial advisors around to help. Some certified financial advisors offer free consultations, while others charge flat or hourly fees. Consider meeting with a few different advisors to find the right one for you

What happens when you withdraw funds from a retirement account

If you leave your money in your 401(k), you’ll be obligated to start taking out required minimum distributions (RMD) once you hit age 73. This is the amount you need to withdraw in order to avoid tax consequences. Your RMD depends on a few factors, and the IRS has resources to help you calculate your amount.

But plenty of people are going to retire sooner than that, and you may even need to take funds from a retirement account to cover an unexpected expense.

Here’s what you need to know about accessing your retirement funds, before and after retirement.

If you make a withdrawal before retirement

You can withdraw money from your retirement accounts before your retirement age, but keep in mind that you’ll likely have to pay penalties and taxes. Typically, that will look something like your current income tax rate plus an additional 10% penalty.

There are some circumstances where you may be able to take money out of your retirement account without penalty, referred to as hardship withdrawals. The events below are the most common hardship withdrawals but keep in mind that some might still incur penalties and fees.

Medical expenses: You may be able to withdraw funds from your 401(k) to cover medical expenses that are not covered by insurance for yourself, your spouse, or your dependents.

Purchasing a primary residence: If you need help covering a down payment and closing costs, there’s a chance you can use your retirement funds.

Education expenses: You may be able to withdraw funds to cover tuition, fees, and related expenses for post-secondary education for yourself, your spouse, or your dependents.

Preventing eviction or foreclosure: If you’re at risk of foreclosure or eviction from your primary residence, you may be eligible to withdraw retirement funds.

Funeral expenses: You may be able to use your retirement money to cover funeral expenses for a deceased parent, spouse, child, or dependent.

If your employer allows it, you can also borrow against your 401(k) with a 401(k) loan. If you leave your employer, though, your loan will be due in full shortly after. If you’re considering this as an option, check with your employer directly to learn about the terms and conditions.

If you make a withdrawal after retirement