Saving money for your golden years is crucial. Without a solid nest egg, you’ll risk struggling to pay the bills once your career ends.
Most seniors need about 70% to 80% of their former income to live comfortably in retirement, and Social Security will only provide around half that amount, if you’re an average earner. As such, you’ll need to save independently during your golden years, and the good news is that you have a number of tax-advantaged retirement plans to help you accumulate wealth.
Types of retirement savings accounts
If you’re saving for retirement in 2020, here are the plan choices that may be available to you:
- Traditional 401(k)
- Roth 401(k)
- 403(b)
- Traditional IRA
- Roth IRA
- SEP IRA
- SIMPLE IRA
- Solo 401(k)
Here, we’ll review each of these options to see what the annual contribution limits entail and whether you’re eligible to fund each account, as different plans have different rules.
Traditional 401(k)s
Employer-sponsored 401(k)s come in two main varieties: traditional and Roth. The upside of a traditional 401(k) is that your contributions are made with pre-tax dollars, saving you money each year you fund your retirement plan.
Imagine you fall into the 24% tax bracket and put $6,000 into a traditional 401(k) in 2020. That alone will shave $1,440 off your 2020 tax liability.
Once your traditional 401(k) is funded, your money can be invested for tax-deferred growth. This means you don’t pay taxes on your investment gains on a yearly basis, as you would with a traditional brokerage account. Rather, you pay taxes when you take withdrawals in retirement.
You’re allowed to access the money in your 401(k) penalty-free once you turn 59-1/2. Then, you’ll need to start taking required minimum distributions, or RMDs, from that account once you turn 70-1/2.
The annual contribution limits for traditional 401(k)s are quite generous in 2020: $19,500 for workers under 50, and $26,000 for those 50 and over. This represents a $500 increase for younger workers compared to 2019, and a $1,000 catch-up increase for older workers.
In addition, you may be entitled to matching dollars in your 401(k) if your employer offers such a program. The exact match you’ll get will depend on what that program looks like and how much you contribute to your 401(k) yourself. But the money you get from your employer does not count toward your annual limit, so if you’re 40 years old and decide to max out at $19,500, and then get another $3,000 in matching dollars from your employer, that’s totally fine.
Roth 401(k)s
Though not every 401(k) plan offers a Roth savings feature, a growing number of plans are starting to incorporate this option. With a Roth 401(k), your money goes in on an after-tax basis, so there’s no immediate tax break for making contributions. But once your account is funded, your invested savings get to grow tax-free, and withdrawals in retirement are tax-free as well.
The annual contribution limits for Roth 401(k)s are the same as those of traditional 401(k)s, as are the rules — you can access your savings penalty-free once you turn 59-1/2, and you must start taking RMDs once you turn 70-1/2. The primary difference, however, is that RMDs from a traditional 401(k) result in more taxes for you as a senior, whereas RMDs from a Roth 401(k) don’t increase your tax burden in retirement, since all Roth withdrawals are tax-free.
Furthermore, whereas there are income limits that come into play with regard to funding a Roth IRA, Roth 401(k)s don’t impose earnings-related restrictions. As such, you can fund a Roth 401(k) even as a higher earner.
403(b)s
A 403(b) works just like a 401(k), only it’s a savings plan available to specific types of workers — educators, nonprofit employees, and those employed by religious institutions. The annual contribution limits for 403(b)s mimic those of 401(k)s: $19,500 for workers under 50, and $26,000 for those 50 and over.
Workers with at least 15 years of service may, if their plans allow for it, be entitled to an additional catch-up on contributions. This special catch-up is calculated as the lesser of:
- $3,000
- $15,000, reduced by the amount of extra contributions made in previous tax years
- $5,000 times the number of years you’ve worked for your employer minus total extra contributions made during previous tax years
Note that this special catch-up is not the same catch-up as the one workers 50 and older are entitled to. If you’re entitled to both catch-ups, 403(b) contributions that exceed the standard $19,500 limit are first applied to the 15-year catch-up, and then to the catch-up for being 50. Let’s say you’re over 50 and are eligible for an additional $3,000 under the special catch-up provision for putting in 15 years of service. If you contribute a total of $25,000 to your 403(b) in 2020, the first $19,500 will count as your regular contribution. Then, your next $3,000 will count as your special catch-up, and your final $2,500 will count as an age-related catch-up.
Traditional IRAs
If you’re self-employed, or don’t work for a company that offers a 401(k) plan, you can save for your golden years in an individual retirement account, or IRA. The annual contribution limit for traditional IRAs in 2020 is much lower than that of 401(k)s — $6,000 for workers under 50, and $7,000 for those 50 and older. These limits are the same as the limits for 2019 — there was no increase.
Otherwise, the rules are the same as those of a traditional 401(k) — your money goes in on a pre-tax basis, investment growth is tax-deferred, and your withdrawals in retirement are taxed. You can access your money penalty-free once you turn 59-1/2, and RMDs come into play starting at age 70-1/2.
Roth IRAs
The annual contribution limits for Roth IRAs are the same as the limits for traditional IRAs: $6,000 for workers under 50, and $7,000 for those 50 and older. Roth IRA contributions are made with after-tax dollars, so there’s no immediate tax savings for funding an account. But investment gains in a Roth IRA are completely tax-free, and withdrawals in retirement are tax-free as well.
One major benefit of Roth IRAs is that they’re the only tax-advantaged retirement savings plan to not impose RMDs. As such, you’ll have the option to leave some or all of that money to your heirs if you so choose.
One drawback of Roth IRAs, however, is that higher earners are barred from contributing to one directly. Here’s where the Roth IRA income limits stand for 2020:
| Tax Filing Status | Contributions Phase Out Once Income Exceeds: | Contributions Are Barred Once Income Exceeds: |
|---|---|---|
| Single, head of household, or married filing separately (and you didn’t live with your spouse during the year) | $124,000 | $139,000 |
| Married filing jointly or qualifying widow/widower | $196,000 | $206,000 |
| Married filing separately (and you lived with your spouse at any point during the year) | $0 | $10,000 |
Note that with the exception of tax filers who are married and file separate returns, the Roth IRA income limits have all increased from 2019, thereby opening the door for more workers to choose this savings option.
If your income it still too high to contribute to a Roth IRA directly, you can always fund a traditional IRA instead, and then convert it to a Roth after the fact. You’ll be liable for taxes on the amount you convert, but you’ll then enjoy the benefits of having that money in a Roth IRA.
SEP-IRAs
If you’re self-employed, you’re not limited to a traditional or Roth IRA for your retirement savings. You can also look at funding a SEP-IRA. Short for “simplified employee pension,” SEP-IRAs allow independent workers and small business owners to contribute much more than what traditional and Roth IRAs allow for. In 2020, you can contribute up to 25% of your net business earnings (which is your earnings minus deductible expenses, including your actual SEP contribution), up to a maximum of $57,000.
While a SEP-IRA may be a good solution for individuals who are self-employed, it’s not always the best savings tool for small business owners. If you own a business that employs other people, you must contribute the same amount, percentage-wise, to your employees’ SEP-IRAs as you do to your own. And that could get expensive.
Otherwise, SEP-IRAs work just like traditional IRAs: Contributions are made with pre-tax dollars, so there’s immediate tax savings involved in funding an account. Investment growth in a SEP is tax-deferred, withdrawals, which get taxed, can be taken penalty-free beginning at age 59-1/2, and RMDs start at 70-1/2.
SIMPLE IRAs
Short for “savings incentive match plan for employees,” the SIMPLE IRA is another savings option available to self-employed workers or small business owners. As is the case with SEP-IRAs, SIMPLE IRAs offer higher contribution limits than traditional and Roth IRAs. In 2020, you can contribute up to $13,500 if you’re under 50, or up to $16,500 if you’re 50 or older.
If you’re a business owner with employees, you must match worker contributions in one of two ways: by matching dollar amounts directly up to a maximum of 3% of your employees’ compensation, or by contributing a fixed 2% of their compensation.
Meanwhile, if you’re self-employed, you can fund a SIMPLE IRA as an employer and an employee. If you’re under 50 and max out your account at $13,500, you can then put in another 3% of your earnings in addition.
SIMPLE IRA contributions are made with pre-tax dollars. Investment growth is tax-deferred, withdrawals, which are taxable, can be taken penalty-free starting at 59-1/2, and RMDs kick in at 70-1/2.
Solo 401(k)s
You don’t need to be employed by an outside company to participate in a 401(k). If you’re self-employed, you can open a Solo 401(k), which is a 401(k) you manage yourself. The rules surrounding Solo 401(k)s mimic those of traditional 401(k)s: contributions are made with pre-tax dollars, investment gains are tax-deferred, withdrawals are taxed and become penalty-free at 59-1/2, and RMDs begin at 70-1/2.
The main difference between a Solo 401(k) and a traditional 401(k) is the option to contribute a lot more money annually. In 2020, you can contribute up to 25% of your net business income, up to a total of $57,000 if you’re under 50. If you’re 50 or older, that limit increases to $63,500, as the $6,500 catch-up that apples to traditional and Roth 401(k)s applies here as well.
What’s the right retirement savings plan for you?
Clearly, you have a lot of choices when it comes to saving for retirement in 2020. But before your head starts spinning, recognize that some of the above may not apply to you. If you’re a public sector employee, for example, then you can’t get access to a 403(b), and if you’re not self-employed, SEP-IRAs, SIMPLE IRAs, and Solo 401(k)s are off the table.
But assuming you have more than one savings option to choose from, here are some questions you might ask yourself to better narrow down your decision:
- How much money can I afford to contribute in 2020? If you’re a higher earner, or are good at managing your money, and want to contribute as much toward retirement as possible, then, assuming you’re not self-employed, a 401(k) could be a better bet than an IRA. Not only will you be privy to a higher contribution limit, but you’ll also have the option to get extra money in the form of an employer match (assuming your company offers one).
- How important is it to me to have more investment choices? IRAs generally offer more investment options than 401(k)s, and with IRAs, you can load up on individual stocks as well as mutual funds. In a 401(k), you’re limited to mutual funds, and so your fees could get expensive, especially if you opt for actively managed funds over index funds.
- Do I need a tax break now, or would I rather have one later? Traditional IRAs and 401(k)s let you lower your tax burden immediately. That’s a good thing if you need the tax savings right away to make funding your retirement account possible. But if you want more flexibility with your money during retirement, then a Roth IRA or 401(k) may be your better choice. Furthermore, if you expect your tax rate to be higher in retirement than it is today, then a Roth account makes sense. That’s because you’ll pay taxes on your contributions at your current tax rate, not your future one.
- How much do RMDs bother me? For some seniors, RMDs are no big deal — the money they’re forced to remove on an annual basis is money they need to pay their living expenses and would be withdrawing anyway. But if leaving a financial legacy behind to your heirs is important, or if you want the maximum amount of freedom with your savings down the line, then a Roth IRA could be your best choice.
Ultimately, there’s no right or wrong answer when it comes to choosing a retirement plan, nor do you necessarily have to limit yourself to just one. For example, if your employer offers a 401(k), you might put half of your yearly contributions into a traditional 401(k), and the other half into a Roth. That way, you get some instant tax savings, but you also get some tax-free money in retirement. Just know that if you’re going to go this route, you’re still limited to either $19,500 or $26,000, depending on your age. If you’re under 50, you can’t, for example, put $10,000 into a traditional 401(k) and another $10,000 into a Roth 401(k).
How much should you save for retirement in 2020?
No matter how much you earn, a good bet is to sock away 15% to 20% of your income for your golden years. But if you can’t manage that, do the best you can. You can also save above the 20% threshold if your earnings allow you to do so. And if you’re older and behind on savings, it certainly pays to ramp up as quickly as you can.
Another thing you should know is that when it comes to building a solid nest egg for retirement, time is one of your most valuable tools. And the longer a savings window you give yourself, the more you’ll get to benefit from compounding growth on your investments.
Compounding, in a simplified sense, refers to earning interest on interest. When you invest your retirement savings and they earn money year after year, you get to reinvest those gains to grow your savings into an even larger sum. As such, if you give yourself a long enough savings window, you can very well retire a millionaire even if you never manage to sock away more than $500 a month in your lifetime.
This table shows you how that’s possible:
| If You Start Saving $500 a Month at Age: | Here’s What You’ll Have by Age 67 (Assumes a 7% Average Annual Return): |
|---|---|
| 22 | $1.7 million |
| 27 | $1.2 million |
| 32 | $829,000 |
| 37 | $567,000 |
| 42 | $379,000 |
All of these are respectable totals — but you can’t help but gasp a little, in a good way, at the potential for $1.7 million by kick-starting your savings efforts as soon as you enter the workforce.
And if you’re curious about the retirement age and return used above, 67 is full retirement age for Social Security purposes for anyone born in 1960 or later. Meanwhile, 7% is just below the stock market’s historical average, so it’s a reasonable assumption over an extended savings window.
The table above is almost meant to illustrate that even if you’re limited to an IRA for your retirement savings, and even if annual contribution limits for IRAs never increase, you can still amass a nice amount of wealth by funding that account consistently.
Be diligent about saving for retirement
No matter what your retirement goals look like, you’ll need money to make them happen. Social Security will provide some income for you once you stop working, but those benefits should not be your primary source of it. The more of an effort you make to save for retirement during your working years, the more freedom and flexibility you’ll buy yourself as a senior, so if you haven’t begun funding your nest egg, make 2020 the year your efforts get off the ground.