The Beginner’s Guide to Retirement- 401(K)& IRA

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Even if you are in your twenties, still paying student loans and living paycheck to paycheck, it is not too early to think about retirement. It might seem that you are in a different era of your life, but saving is a matter of habit, and good habits formed in your youth are the ones that you will thank yourself for later.

There is no one best option to do so, but you must be informed and choose according to your earnings, lifestyle and expected needs. You do not have to become a part-time financial consultant, but have a simple plan and follow it thoroughly. As you enter new stages of your life, such as marriage or starting a family, your savings should change accordingly. Always discuss financial matters with your partner to find the best solution.

Types of retirement savings

Let’s first make sense of the options available to a working individual and the flavors these come in.

401(k) vs. IRA

First introduced in the 80’s to supplement pension plans, a 401(k) is a savings plan partly sponsored by the employer. Money is invested by a fund administrator in a mix of shares and bonds, keeping a conservative composition of the portfolio, so little risk, little but certain gain. The name comes from the part of the tax code that governs it, and you can only get one if you are employed.

The good part is that such a plan comes with your employer’s promise to match some of the funds you contribute, up to a guaranteed percentage of your gross salary, around 3% of free money. The total contribution of you and your employer is limited to your yearly salary. The downside is that you will not be able to get access to the money deposited by your employer right away. As a protection method against early leaving the company, you need to become “vested,” a process that takes a few years.

The IRA (Individual Retirement Agreement) is a plan that you voluntarily sign up to and is limited to $5500/year or $6500/year if you are over 50 and is subject to income limits depending on your marital status. The money you put in an IRA are a plus to your 401(k), and it can even be inherited by your kids after your death. Beware of exceeding the limit, or you could be subject to tax on excess IRA contributions, just withdraw the money that exceeds the prescribed amount.

Traditional vs. Roth

Traditionally, pension contributions are not taxed when the deposit is made but will be taxed during withdrawal. The logic of choosing such an arrangement is that in your later years you will be in a different taxing bracket and you will not feel the pressure so much. Furthermore, as your money grows over the years, the tax burden will feel less.  Choosing the traditional plan also means you will keep money in the account at least until you are 59 ½ or face penalties.

In 1997 Senator William Roth Jr. from Delaware introduced the Taxpayer Relief Act. The name Roth 401(k) or Roth IRA is given in his honor. Specifically, choosing a Roth plan means that you contribute with money that has already been taxed once. Therefore you will not be paying any taxes in the future. This is a great option for people who expect to be in the same or a higher tax bracket in retirement.  Not all employers offer a 401(k) Roth.

Having a Roth 401(k) is beneficial since it can turn into a Roth IRA when you leave the employer, therefore your money goes with you.

What is the best option for you?

Now that you have a clear understanding of the options available it is time to decide what makes more sense for you, considering your particular situation. The ideas discussed here are simple guidelines, therefore using a simulator o calculator is always a good idea when deciding your pension investment plans.

If your employer offers a 401(k), you should take advantage of this first and strive to contribute at least the maximum matched amount, or you are just leaving free cash on the table. Most employers offer only one option, so you do not get to choose between a Roth or a Traditional 401(k). In the rare case, you have a choice, think about the tax bracket you expect to be in during retirement. A lower level demands a traditional approach, while a higher one is more suitable for the Roth.

Age

For young contributors, a Roth account is the best since they are most likely in a low-income tax bracket. Even if you are past your roaring 20s, you can still benefit from a 401(k) Roth, especially if you are a high earner who cannot benefit from an IRA. Get rid of taxes today and let your money accumulate interest until your late years. If you want and are eligible for an IRA, you can get a traditional one up to 70 ½ and a Roth any time, regardless of your earnings.

Taxes

The main difference between a traditional and a Roth is related to paying taxes. Considering the inflation rates and dropping in a different tax bracket when you withdraw the money, you are better off with getting that problem out of the way with a Roth.

Required minimum distributions

Starting at 59 ½ you can withdraw funds, but in 401(k) you are forced to do so at 70 ½. However, if your plan was a 401(k) Roth, you can just convert it to an IRA Roth and keep your funds for as long as you want, even transfer it to your kids or grandchildren untouched. A traditional 401(k) must be distributed in the lifetime of the original owner.

If you want to withdraw money before 59 ½, expect to pay a 10% penalty, unless you intend to use that money for healthcare, buying your first home or education.

Deductions

Since contributions to traditional plans will be taxed in the future, now you can deduct them completely or at least part of them, depending on your income. If you are looking to deduct your IRA, just file form 8606. Roth Plans are not deductible from taxes but also aren’t subject to earning limits.

Final thoughts

When deciding your pension plan be sure to take into consideration all numbers or you might end up with a sub-par deal. Be informed about maintenance fees, opening or closing taxes, and other subscription payments. Ask your provider about the ways you can make deposits and ask about your account.

Be sure to ask about the investment strategy and the profit rates they attained to compare different providers. Moreover, remember, it is not a choice of 401(k) or IRA, it is a selection of what combination of these, from which provider, gets you the more money on the long run. You have the option to sign up for a new plan each year in April.

 

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