At Money Talks News, we talk a lot about retirement.
But maybe you’ve read through those articles and felt a little lost by the acronyms and tax-law references sprinkled in between all that talk of compound interest. Don’t feel bad. The government doesn’t make anything easy.
Read on for an easy-to-understand overview of two of the most common retirement plan types — 401(k)s and IRAs — and how to choose the right plan for you.
401(k) retirement plans
Traditional pensions have been shown the door by many employers, who often offer a 401(k) retirement plan instead.
For-profit companies can sponsor 401(k) plans, meaning they can offer them to their employees. Nonprofits and state and local governments can sponsor similar retirement plans, known as 403(b) plans and 457(b) plans, respectively.
The name “401(k)” is a reference to the section of federal law that defines 401(k) retirement plans. The same is true of “403(b)” and “457(b).”
Employer matching funds: Many employers will match a portion of the money you contribute, or add, to your 401(k). In other words, they will put some company money in your 401(k) if you put some of your paycheck in it. For example, an employer might match every dollar you contribute, up to an amount equal to 3 percent of your income.
Employer matches make 401(k)s the ideal place to save money for retirement. If your employer offers a match, contribute whatever it takes to pick up the maximum match. Otherwise, you’re leaving free retirement money on the table.
For help figuring out how much money you must contribute to get your employer’s maximum match, check out “Ask Stacy: How Much Should I Contribute to My 401(k)?”
Be aware, however, that some companies require you to work for them for a certain length of time before you are considered vested. Being vested simply means that, if you leave a job, you will get to keep all the money the employer contributed to your 401(k).
Contribution limits: In 2017, you can contribute:
- Up to $18,000 to regular 401(k) plans. If you are 50 or older, you can also contribute an additional $6,000 as a “catch-up” contribution.
- Up to $12,500 to SIMPLE (Savings Incentive Match Plan for Employees) 401(k) plans, which are generally available to small businesses. If you are 50 or older, you can contribute an additional $3,000.
Once money is placed in a 401(k), it generally cannot be withdrawn until you reach age 59½ without having to pay a penalty.
IRA retirement plans
After a 401(k), the second-most ideal place to save money for retirement is probably in an IRA, which stands for “individual retirement account.”
An IRA works like a 401(k) in that you are investing money and letting it grow until retirement. Again, you generally can’t withdraw money without penalty until age 59½.
Your employer does not need to sponsor an IRA for you to take advantage of one, though. You can set up an IRA on your own.
Contribution limits: For 2017, you can contribute up to $5,500 to IRAs. If you’re 50 or older, you can contribute an additional $1,000 to “catch-up.”
These contribution limits apply regardless of how many IRAs you have. So if you’re 45 and have two IRAs, you could put $3,000 in one and $2,500 in the other.
Roth vs. traditional
There are two types of IRAs and two types of 401(k)s: traditional and Roth.
Traditional plans are sometimes also referred to as “regular” plans.
Roth plans are relatively new. They are named in honor of William Roth Jr. The former Delaware senator was instrumental in establishing the federal law that established Roth plans in 1997.
Taxes: One key difference between Roth and traditional plans is how contributions are taxed.
You can invest pre-tax income in traditional accounts. So one advantage of traditional accounts is that when you contribute money, you can generally write off the contribution as a tax deduction, thereby lowering your tax bill. One disadvantage of traditional plans is that you pay taxes on the money as you withdraw it.
You can invest after-tax income in Roth accounts. So in effect, Roth plans are a mirror image of regular plans. When you contribute to a Roth account, you don’t get a tax deduction. But you don’t have to pay taxes on your withdrawals in retirement. So by skipping the tax break during your working years, you get tax-free money when you take it out.
To learn more about the benefits of Roth IRAs, check out “5 Reasons a Roth IRA Should Be Part of Your Retirement Plan.”
Required minimum distributions: Traditional IRAs generally require participants to begin withdrawing fixed amounts each year — known as required minimum distributions, or RMDs — by age 70½. RMD amounts depend on multiple factors, like the balance of the account. Failure to withdraw the RMD can result in hefty fines.
Roth IRAs are not subject to RMDs — another benefit of that type of retirement plan.
All employer-sponsored retirement accounts, including 401(k)s, are generally subject to RMDs by age 70½.
Picking the right account
Assume you deposited $5,000 and assume it’s grown to $50,000 by the time you retire. With a Roth plan, you’ll have paid taxes on the $5,000 you originally deposited, but you’ll pay nothing on the rest. With a traditional account, you’ll pay taxes on the entire $50,000. Now you see the appeal of the Roth.
However, using a Roth also means missing out on lots of potential tax deductions during your working years. The math is complicated, but a 2014 report from T. Rowe Price found that putting money in a Roth IRA almost always gives you more disposable income in retirement than if you had put the same amount in a traditional IRA.
There are also tons of online calculators that can help you decide which way to go. Simply do a web search for “Roth vs. traditional calculator.”
How’s your progress on saving for retirement? Share with us in comments below or on our Facebook page.
Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.