Retirement Accounts With Flexibility

Retirement Accounts With Flexibility
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If you're planning to open a retirement account, flexibility can become an important consideration, especially when you expect to contribute several thousands of dollars annually. Generally, the money contributed is expected to stay in your account until you take distributions no earlier than age ​59 1/2​. However, retirement accounts often allow for either early withdrawals or loans, but these options can cost you unless they're for a hardship or qualified expense. Take a look at some retirement account options with flexibility and the considerations involved with using the money.

Introducing Retirement Accounts and Flexibility

Whether you need to tap into your retirement account to make a first home purchase or cover unexpected medical expenses, you'll find that the flexibility available will depend on the type of retirement account you have. So, it's important to choose the right one for your savings.

Retirement accounts through your employer will be categorized as either defined benefit plans or defined contribution plans. Defined benefit plans – such as pension plans – are designed to give you a set amount of money every month when you retire, and contributions usually come from your employer rather than you. Defined contribution plans – such as 401(k) accounts – allow for contributions from both parties, including matching employee contributions, and you have more flexibility for taking money out from these employer-provided plans.

There are also individual retirement arrangement (IRA) accounts such as traditional and Roth IRAs that you can open through a brokerage. These are usually funded entirely by you and have more flexibility for early withdrawals.

Looking at 401(k) Accounts

Private employers commonly offer 401(k) accounts that allow employees to contribute money from their paychecks and possibly get some type of matching contribution from the employer. These plans usually apply to full-time employees who've worked with the company for a year and reached the age of ​21​. A vesting schedule applies where employer contributions become owned by you on a set schedule, so if you leave your employer before this happens, you lose those employer contributions.

As of 2021, such accounts let you invest ​$19,500​ annually (​$26,000​ when you're 50 or older) in this kind of account. Your employer may offer both Roth and traditional 401(k) accounts where tax benefits now and later vary. For example, Roth 401(k) accounts require you to pay taxes on the income contributed the year you do so but are tax-free once you withdraw the money after retirement age. Traditional 401(k) accounts let you get a tax deduction now, but you have to pay income taxes on withdrawals upon retirement.

There are also special types of 401(k)s and related accounts to be aware of, and they all work similarly. For example, public school, church and some other non-profit employees can access 403(b) plans, while 457 plans are a similar option for government workers. There are also SIMPLE 401(k) accounts that are for small business owners, allow for a lower maximum of ​$13,500​ in employee contributions and have all funds vested immediately.

Whether you need to tap into your retirement account to make a first home purchase or cover unexpected medical expenses, you'll find that the flexibility available will depend on the type of retirement account you have.

Flexibility Through 401(k) Loans

When you need some money now but expect to be able to pay back the borrowed amount in no more than ​five years​, you might consider taking out a 401(k) loan. This option can also work for related retirement accounts such as 457(b)s and 403(b)s. The availability of such loans depends on your employer since there's not a law that mandates these loans. But if your employer allows it, you could borrow an amount that depends on the account balance and how much of it is already fully vested.

The IRS rules let you borrow a maximum of ​$10,000​ if the vested amount is no more than that. Otherwise, the limit is the lesser of ​$50,000​ or half your vested balance. So, if you have saved a substantial amount of money, you might easily borrow enough money from your 401(k) to pay for a home down payment, college tuition or another large expense. Keep in mind that your employer can have additional rules, and you can expect to pay interest on the 401(k) loan and be subject to loan limits.

If you decide on benefiting from the flexibility of 401(k) loans, you'll have to follow some rules to avoid the IRS reclassifying the loan as an early withdrawal and penalizing you. Unless you're taking the money to buy a primary home, you'll have a maximum ​five-year ​repayment period, and the IRS requires quarterly payments at a minimum. Usually, you'll have the loan payments taken out of your paychecks. If you end up getting fired or quitting, beware that your employer may ask for a lump sum of the balance or else reclassify it as an early withdrawal with the tax implications.

Flexibility With Early 401(k) Withdrawals

Your employer's plan rules may allow you to take an early distribution before age 59 1/2 from a 401(k) or similar defined contribution account. However, they might also only allow you to do so in specific situations and restrict the withdrawal to the amount needed. For example, your employer might just allow for hardship distributions from a 401(k) for reasons such as buying your primary home, paying for funeral expenses, handling medical care costs or covering tuition for yourself or a qualified family member. This means you might have trouble if you need the money for a purchase that the plan rules deem voluntary or not immediately necessary.

When taking an early withdrawal from a 401(k), the funds need to have been fully vested or else they're not yet available to you. Further, the tax consequences will depend on whether it's a hardship withdrawal or regular early withdrawal and whether you've got a traditional or Roth 401(k). The reason for a hardship withdrawal also affects penalties.

Taking a hardship withdrawal can help avoid the 10 percent penalty, but it depends on the situation since certain reasons like buying a house or paying for college don't waive this penalty. In addition, both regular and hardship withdrawals from a 401(k) are subject to regular income taxes on the amount. If you have a Roth 401(k), however, you can avoid taxes and penalties on 401(k) withdrawals when it's just the contributions (and not earnings) withdrawn, and the account has existed for ​five years​ or longer.

Exploring IRA Options

Whether you are self-employed, work for a company that doesn't offer 401(k) accounts or you want an additional account to save money, then you can consider one of the IRA options available such as traditional and Roth IRAs. Both plans generally allow you to save ​$6,000​ annually (​$7,000​ if at least 50) as of 2021, and you usually put the money in the IRA yourself. You can simply sign up through one of the many brokerages and make contributions up to the limit as you wish, but you'll need to fall under the income limits for Roth IRA contributions.

As a bonus, you can take the money out whenever you need it, although tax considerations apply. As with 401(k)s, a traditional IRA uses pre-tax money and offers tax benefits now, while a Roth IRA uses after-tax money and gives you tax benefits upon withdrawal. Therefore, the Roth IRA offers the most flexibility for withdrawals since you can worry less about paying taxes and penalties when withdrawing contributions (and not earnings) early, given you've had the account for ​five years​.

While less popular, SIMPLE IRA and Simplified Employee Pension (SEP) plans are two IRA variations to be aware of. As an employee, you'd set up a traditional IRA, and both of you can contribute to a SIMPLE IRA, while the employer would contribute to the SEP. There aren't any vesting periods with these accounts like there would be with a 401(k). The max contribution is ​$13,500​ for SIMPLE IRAs, while employer SEP contributions are limited to either ​25 percent​ of your salary or ​$58,000​, whichever figure is smaller.

Flexibility Through Early IRA Withdrawals

You can't take a loan from any kind of IRA due to the IRS rules against using these accounts as collateral. However, you can withdraw money before age 59 1/2 whenever you need it and not have to worry about restrictions that an employer might put on early withdrawals like with 401(k) and similar accounts.

You'll need to pay taxes on your withdrawals if you have a traditional IRA or you have a Roth IRA and either withdraw earnings or haven't had the account long enough. The income taxes are based on your normal tax rate for the year. The ​10 percent​ tax penalty (​25 percent​ for SIMPLE IRAs not yet ​two years​ old) typically also applies to early withdrawals from non-Roth accounts.

However, the good news is that the IRS offers several exceptions for paying the typical early withdrawal penalty for IRAs. These include common reasons you might need the money for, such as becoming disabled, attending college, making a down payment on your first home (up to ​$10,000​) and paying medical bills or insurance premiums.

Less Flexibility With Pensions

Of the retirement plan options available, you'll find pensions less flexible since you typically can't take any distributions until you reach the retirement age set by the plan. These plans usually have your employer contribute money corresponding to a part of your salary each year. When you retire after the required years of service and reach the minimum retirement age, you might get a certain amount of money each month from the plan, or you could opt for a lump-sum payout.

However, you might have some flexibility if your plan administrator allows you to take a loan from your pension benefits. The loan limit works like 401(k)s, where you might borrow as much as half the vested amount or ​$50,000​, whichever is less. You'll be expected to make quarterly payments with interest and have the money paid back within five years. Otherwise, it can become a taxable distribution with the negative tax consequences applying.

Considerations for Goal Planning

There are always some pros and cons to weigh whenever you borrow or withdraw funds early from a retirement account. For example, a plan loan offers flexibility to make a needed purchase but comes with the trade-off of interest, while an early withdrawal can lead to taxes and penalties. Therefore, planning for future goals and expenses becomes important so that you can avoid needing money from retirement accounts and instead let the money continue to grow and benefit you later on.

For example, if you've got goals to both buy your first home and save for retirement, you'll want to look at your budget and assess your priorities. You might find that you can afford to allocate some savings to both at once or that you really need a home and are willing to put off contributing to retirement for a while. In that case, you might decide to maximize contributions as soon as you've saved for the down payment and other upfront costs.

If you do put funds toward retirement, you'll be able to list the accounts as assets when you apply for a mortgage or other type of loan, and this can help when the lender calculates your assets minus liabilities – your net worth. You'll still need to keep in mind, though, that other factors like a credit score will matter as well when using your retirement fund as an asset for a loan.