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By Hal Bundrick, NerdWallet
A ball drops into a scoop, which tilts down to a ramp, where the ball rolls down and lands into a bucket of water, which pulls a string that tosses a cracker to a parrot that flies off a perch and rings a doorbell.
No doubt, you’ve seen pictures of those Rube Goldberg “complicated machine” inventions. Contraptions that are way more complicated than they need to be to get the job done. That’s how saving for retirement can seem: mystifying and very complex. Let’s simplify the process.
Your individual plan
You can start with an individual retirement account, or IRA. It’s yours for life, and you can guide the investment process in a manner in which you are most comfortable. This is the foundation account for your retirement savings and is easy to establish.
IRAs come in two versions: Traditional and Roth. It simply boils down to a matter of if you want to take a deduction when you file your taxes and pay the income tax later (Traditional) -- or pay the tax now on your contribution and never pay tax again (Roth).
Advisors will often ask you to guess when you will be in a higher tax bracket: now or in retirement. A lot of people assume that they will be in a lower tax bracket in retirement and opt for the Traditional IRA. Younger workers usually assume they will be in a higher tax bracket in retirement and go for the Roth. Either way, IRAs should serve you well -- and in fact, you can contribute to both types, up to the legally allowed limit in 2014 of $5,500 ($6,500 if you are 50 or older).
Please note, however, that tax deductions on Traditional IRAs can be phased out if you participate in a company-sponsored retirement plan and earn a certain level of income. There are income restrictions on Roth IRAs, too.
Your workplace plan
An IRA will only get you so far, because your contributions are limited to relatively small amounts. That’s why you may want to turn to your workplace retirement plan for the heavy lifting.
Since private pension plans are mostly a thing of the past, the retirement plan most commonly offered to employees by American businesses is the profit-sharing plan known as a 401(k). While these “defined contribution” retirement plans can be the cornerstone of a successful retirement savings strategy, nearly all of the responsibility falls on you to make the right decisions. Employers, also called “plan sponsors,” and the advisors and record keepers that help run the 401(k) will help – to a point. But the final decisions regarding investments, contributions, withdrawals and all the rest are yours.
As with IRAs, 401(k) plans come in Traditional and Roth versions.
There are two big differences between the IRA and the 401(k). One is the maximum contribution limit: The 401(k) allows you to set aside $17,500 a year, with an additional $5,500 for participants 50 and over (2014 limits). That’s a sizable difference from the maximum you can put into an IRA.
The other benefit is the potential employer match. Some companies will match your contribution up to a certain amount. That could even double your money right off the bat, depending on your employer’s policy.
For business owners
If you own your own business, you have additional retirement savings options. Probably the most popular plan for the self-employed is the SEP IRA. For 2014, you can contribute up to 25% of your compensation or $52,000, whichever is less, to your SEP IRA. This allows you to enjoy a significant savings rate, though there is a special income computation that must be used for self-employed contributions. But paperwork is minimal to start the account, and typically no annual reports are required to be filed.
The income account
Finally, another retirement savings account to consider is your “income” account. This is your savings or brokerage investment account where you keep your emergency and contingency funds. Your 6-month emergency fund can be kept in money market funds for quick access. Anything over that is invested. Over the course of a working career, your savings plan may work like this:
It may not be as much fun as watching a Rube Goldberg machine ring a doorbell, but when it comes to retirement – it gets the job done.
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