Retirement Accounts: 401(k) and IRA
Few employers these days offer guaranteed life pensions, and Americans are increasingly relying upon self-funded retirement accounts. While this provides workers with greater control over their financial wellbeing in retirement, it also creates a problem for already-busy workers who now feel as though they need to become financial experts in order to effectively plan for retirement. Selecting account types and investments can be complicated and time-consuming for the average investor.
There are two main types of retirement savings plans, each with two variants: the 401(k), which is set up through your employer, or the Individual Retirement Account (IRA), which you establish individually, both of which come in either the traditional or Roth forms. Traditional retirement savings plans lower your current tax burden and are then taxed as income upon distribution, while Roth plans come from your post-tax income, and are then tax exempt when distributed upon retirement. In some cases, a combination of different accounts may be best for maximising the benefits to you.
The 401(k) is one of the most widely used retirement savings plans in the United States, in which both you and your employer agree to a salary deferral, which will then become your post-retirement income. These can be either traditional 401(k)plans, in which you won't pay tax on the deferred amount now, but will when you go to withdraw the money, or a Roth 401(k), which has you pay tax on contributions now in return for tax exemption upon withdrawal. Up to 94% of these plans even come with matching funds from your employer, effectively doubling the money you are putting aside for retirement. Annual contributions are capped, but if you start your savings after age 50, or underfunded your plan in recent years, you may enjoy higher contribution limits, allowing you to set aside money more quickly for your upcoming retirement and make up for lost time. As of 2018, individuals can contribute up to $18,000 per year in their 401(k), or $24,000 per year if you are age 50 or above. Depending on the plan that your employer has chosen, you are then given the ability to choose between a predetermined set of investments, or your portfolio is managed by an outside professional. Employees can withdraw from their 401(k) prior to retirement, but at a penalty.
Traditional IRAs are funds that you pay into in order to create a post-retirement source of income for yourself, independently of your employer. Contributions are not taxed, but when you withdraw money from traditional IRAs, the funds are treated as income and are subject to income tax, making them a deferred tax investment. You have to start withdrawing the money by age 70. Roth IRAs are not tax deductible at the time of contribution, but are tax exempt when you start making withdrawals. Both traditional and Roth IRAs allow contributions of up to $5500 per year ($6500 per year if you are age 50 or above).
Deciding whether to contribute to a traditional or Roth IRA depends on whether you think your retirement income will be greater or less than it is during your working years. If you expect to be in a higher tax bracket upon retirement, a Roth IRA may be a better for you, because the amount will already have been taxed at your current lower rate. On the other hand, if you expect to be in a lower tax bracket, you may want to opt for a traditional IRA, so that you pay taxes at the lower future rate instead of your higher current rate. For many investors, this may be a matter of guess work, but generally, if you are good at putting aside extra money for your retirement, a traditional IRA will give you more money to re-invest, while a Roth IRA creates an incentive to save more upfront.
The chart below summarizes the key attributes of each type, and your financial advisor can help determine the best strategy for you, whether that is a single plan or a combination of them.