Retirement may seem distant, but according to data from the American Association of Retired Persons (AARP), nearly half of American retirees are primarily concerned about running out of money prematurely.

Choosing Your Retirement Plan

In the United States, there are primarily two types of retirement accounts: workplace plans—such as 401(k)s and IRAs—both of which offer tax advantages to reduce income. It's important to note that you cannot withdraw funds from these accounts before retirement age (typically 59.5 years) without paying a 10% early withdrawal penalty, plus any applicable income tax.

401(k) plans are typically offered by employers to employees as retirement accounts. Each time you receive a paycheck, a portion is set aside and stored for future use. For those under 50, as of 2022, the IRS allows you to contribute up to $20,500 annually through a 401(k); for those 50 and over, the catch-up contribution increases to $27,000. In 2023, contributions for those under 50 are $22,500, and for those 50 and over, it's $30,000.

There are various types of 401(k) plans with different adapter types. We will discuss the two most common types: Traditional 401(k) and Roth 401(k), with the main difference between them being taxation over time.

With a traditional 401(k), you get tax deferral benefits. When you deposit funds into a traditional 401(k), the money from your paycheck goes into the retirement account and taxes are deferred—meaning if you, for instance, earn $60,000 this year and deposit $5,000 into a traditional 401(k) plan, then by 2022, you will only be taxed on $55,000. However, the taxes don't disappear. While you receive tax deferral benefits upfront, when you withdraw funds from the account during retirement, you will pay taxes based on future tax brackets.

If you anticipate being in a lower tax bracket during retirement, a traditional 401(k) may be the best way to minimize overall tax payments, as your future tax rate might be lower than the initial rate when you deposited the funds.

With a Roth 401(k), you pay taxes today, but enjoy tax-free withdrawals later. When you contribute to a Roth 401(k), you don't get tax deferral benefits today. Even though you're contributing to retirement after-tax, the benefit is that any income, taxes, interest, and capital gains in your account all belong to you, as they can grow tax-free (with restrictions). Consider whether this strategy makes sense for you—paying more taxes upfront, but having no one to accurately predict how tax rates will adjust 30 or 40 years from now.

Employer Matching Programs

In addition to tax advantages, one of the most significant features of a 401(k) is the possibility of direct matching contributions from the employer.

Here's how it typically works: many companies offer 401(k) matches, for example, they might match 3% of your annual salary if you contribute to your retirement account. If you earn $60,000 annually and contribute 3%, that means you save $1,800, and your company puts in $1,800 on your behalf.

However, the specifics—and existence—of employer matching can vary. Some companies may only match 50% of what you contribute. So, if you put in $1,800, they might contribute $900. There could also be other limitations. For instance, you might have to work for the company for a certain number of years to be eligible for their match; employers may also have termination matches. Nonetheless, if your job offers this benefit, saving in a 401(k) might be a good idea, or simply contributing enough to get the match.

Usually, your employer selects the plan administrator for the account. But if you leave your job, you're free to roll the check into a retirement account of your choosing or one associated with your new employer.

Individual Retirement Accounts

IRAs are individual retirement accounts that are completely separate from your employer, and you can have an IRA with many financial institutions. Like 401(k)s, IRAs also come in various types. Some of the most common types are Roth IRAs and Traditional IRAs. The main difference between Traditional IRAs and Roth IRAs lies in how funds in the account are taxed.

In 2022, for those under 50, contributions to both Traditional and Roth IRAs are capped at $6,000 annually; for those 50 and over, the cap is $7,000. Generally, these exemption years increase annually to keep up with inflation cycles—by 2023, you'll be able to contribute $6,500 (or $7,500 if you're over 50).

Traditional IRA

Similar to a traditional 401(k), funds can be deposited into a traditional IRA with tax deferred, potentially offering tax deductions based on your income. When taxes are taken upon withdrawal during retirement, you'll owe taxes on the entire amount. Although anyone with income can contribute to a traditional IRA, eligibility for tax deductions depends on your income level and whether you and your spouse have access to workplace retirement plans.

Roth IRA

Similar to Roth 401(k)s, with Roth IRAs, contributions are made after-tax when deposited into the account. However, when funds are withdrawn during retirement, if certain conditions are met, these funds (and any earnings) are tax-free.

They're named Roth IRAs and Roth 401(k)s because the legislation for these retirement accounts was proposed by Senator William Roth in 1997.

Other Taxes and Penalties

While retirement accounts can offer significant tax advantages, you must understand their provisions to see if they're suitable for your situation, as these accounts often come with some restrictions. One significant issue is that before retirement age (typically 59.5 years), you cannot freely withdraw funds without incurring a penalty of 10% in addition to any applicable breach fee.

How Much Should You Save?

The American Association of Retired Persons (AARP) states that retirees may spend between 70% to 80% of their pre-retirement income annually. If someone earns $100,000 before retirement, their goal might be to spend around $75,000 annually, but it might not be enough. Some financial planners aim to use 75% to 85% of annual income for retirement, and retirement calculators can help you understand where you stand in specific periods with different potential rates of return.

Financial planners suggest using the "4% rule" to guide your annual withdrawals for retirement. According to this, you withdraw 4% of your retirement income annually.

Alternatively, you could try to predict how much money you'll need after retirement. By multiplying your yearly expenses by 25, you can calculate your target amount. For example, if you spend $40,000 annually now, you'll need $1 million to maintain a consistent retirement lifestyle.

For some, this estimate might be too low, as when this concept first emerged, it assumed greater support from public systems like Social Security and higher interest rates. Nonetheless, this principle still holds to some extent. If your investment returns cover your expenses annually, it's a good starting point. Still, you shouldn't rely solely on a rule or formula to plan your retirement. Starting early is ideal as you may only have 30 or 40 years to save, and it might take

 $1 million (or more) to live comfortably in retirement.

Starting the 4 Steps to Retirement

If you haven't started saving for retirement yet, do so as soon as possible. Starting retirement age planning early reduces your tax burden at retirement age, at least the goal is to take full advantage of employer matches in a 401(k)—it's free money.
Strive to save 12% to 15% or more of your income in retirement accounts. If you're just starting out and can't afford too much, you can also try setting a goal to increase by 1% annually.
Pay off debts, especially high-interest debts, so you'll have more investment opportunities rather than paying interest on accumulated debts.
Take the time to understand how your tax burden is invested and understand any fees involved. Generally, the closer you are to retirement, the more likely it is to shift tax-burden investments from higher-risk, higher-return assets (stocks) to lower-risk assets, such as US government bonds.