With underfunded retirement accounts, the government implemented several benefit plans in hopes of motivating more Americans to save and invest in their future. The first retirement option was the 401k in 1982, followed by the traditional retirement account (IRA), and lastly the Roth IRA. We’ll be taking a closer look at all three retirement options, how they differ from one another, and which one may be the best for you.
The 401K was first developed in 1978 as an option to Company Pension funds. Original company pension funds were designed so that a retiree could benefit from a fixed payment for the rest of their life.
However, this became unrealistic in a modern working world. To receive a pension, most companies required at least 30 years of service; This became more difficult in a job market that was becoming more dynamic. Not to mention, as life expectancy increased, the cost of funding pensions became more expensive. Many companies eventually decided to opt for the cheaper route by offering 401K’s.
By offering their employees 401K’s, employers do not handle retirement funds directly. Instead, third parties are compensated to manage their employees retirement accounts. With a 401K, a portion of the employees income is deducted before taxes and added to their accounts. The employee can then decide if they would like to invest in stocks or bonds, or a mix of different investment funds. Some companies even match the amount of the employees deduction to help encourage them to save for their retirement.
Since the 401K is specifically designed to help grow the beneficiary’s retirement, there are some restrictions. If a withdraw is made before the retirement age (59 1/2), a penalty of 10% will be incurred on the withdrawn amount. Also by withdrawing the amount early, it becomes taxable income. However, any growth in the account or dividend income will not be taxed. One of the primary benefits of having a 401K is that your taxable income is reduced by the amount of your deductions.
If your employer doesn’t offer a 401K, or you are self employed, then a traditional IRA may be an option for you. A traditional IRA offers the same benefits as a 401K. Many commercial banks offer traditional IRA’s, along with brokerage houses, and even your local credit union.
If an employee leaves their job, they can even transfer their existing 401K into an IRA, usually without incurring taxes or penalties. These funds can also be used to invest in bonds, stocks, and other assets which grow tax exempt profits.
Similar to the 401K, withdrawing before the retirement age will result in a penalty along with that money being taxed. Also, starting at the age of 70 1/2, the beneficiary must make withdrawals, usually a mandatory minimum set by the IRA.
Anyone under the age of 70 1/2 that makes income which is taxable can contribute to an IRA. As long as the contributions are within the annual limit ($5,500 for those under 50, $6,000 for those over 50 as of 2017), contributions are fully tax deductible. This limit may be less if you have a 401K or other retirement plans. If your spouse has a 401K or an IRA then these limits can change based upon the combined income.
There are also retirement plans which offer unique perks, but without the added tax benefits. A Roth IRA falls under this category. Any withdrawals on a Roth IRA are tax free, however deductions are not tax deductible. However, this can work toward your benefit if you plan to withdrawal money early. Withdrawals can be taken out at any age without being taxed or penalized since the original contributions were already taxed. But if you have any earnings on your investments, withdrawing these may incur penalties or taxes before the retirement age.
Contributions on Roth IRA’s are equivalent to traditional IRA’s. Earnings withdrawn after the age of 59 1/2 are tax free.
401K vs. Roth IRA and Traditional IRA
If you are employed with a company which sponsors a 401K plan, then this is the easiest step toward providing for your retirement. Remember, you can always transfer to another IRA without fees or penalties if you think it would be more beneficial to you.
401K’s should be effortless in setting up since your company pays for them to be managed. Also, if your company matches your contribution, then the 401K would definitely be the better choice since you’re practically doubling your retirement. Lastly, your company sponsored plan will have guidance on which funds to invest in, specifically for your financial goals and income.
If you have a 401K, this does not mean you cannot open an IRA. A traditional IRA and 401K are nearly identical, so if you have a 401K then you can also open up a Roth IRA. Without taxes and penalties on withdrawals, a Roth IRA could be useful in the case of emergencies, unlike a 401K or traditional IRA.
Opening an IRA
Brokerages, credit unions and banks all provide IRA’s. You will need a social security number and a bank account to fund the retirement account. When choosing where to open your account, make sure to understand all the fees, penalties and restrictions. Some companies even waive initial fees if you open a bank account or account online with them.
When selecting which account to open, keep in mind the type of funds and products which are offered. There are some companies that have plans which are specifically designed for your income and financial goals and make investing more automated. Other companies may offer numerous funds or assets to invest in, but let you trade the stocks and/or bonds manually. Some companies have low cost commissions on trading if you plan to be more risky with your investment.
Before deciding, it is important to know how much you plan on needing for your retirement. This will give you an idea of how much you should be contributing each pay period and how long you will have to work until retirement. Take the time to learn about the various types of retirement accounts and the different benefits they offer, this will give you an advantage when choosing the right retirement plan for you.