When it comes to saving money for retirement, Americans have a wide range of different options from which to choose. This can be both good news and bad news: It’s good in the sense that having multiple options makes it easier to select the one that’s best for your retirement savings goals and resources. But it can be bad if all the different choices cause confusion and, eventually, “analysis paralysis.”
To help clear up some of the potential confusion, we’ll take a close look at two of the most popular types of qualified retirement plans: the Individual Retirement Account (IRA) and the 401(k) plan.
IRAs: The Granddaddy of Retirement Savings Accounts
Since 1975 when they were first introduced, millions of Americans have used IRAs to help secure their retirement future. The beauty of IRAs is that they not only provide an easy way to save for retirement, but they may also offer an immediate tax break. Depending on several different factors, you may be able to deduct your annual IRA contributions and thus lower your current tax bill.
There are two different types of IRAs: traditional IRAs and Roth IRAs. The latter were introduced in 1997 and named after Senator William Roth, who sponsored the legislation that created them.
With a traditional IRA, annual contributions are generally tax-deductible if you do not participate in an employer-sponsored retirement plan. If you do participate in a retirement plan at work, the amount of your deduction will be limited or eliminated based on your income. Traditional IRAs offer retirement investors the potential to benefit from long-term, tax-deferred asset growth. Money grows without being taxed until distributions begin, at which time ordinary income rates apply.
Roth IRAs, meanwhile, are different from traditional IRAs in several key respects. First, Roth contributions are made with after-tax income, so you do not receive a current tax deduction as you do with a traditional IRA. However, this is offset for many people by the fact that Roth IRA earnings are tax-free when withdrawn. In contrast, traditional IRA earnings are just tax-deferred — taxes must be paid at whatever your ordinary income tax rate is when you start taking distributions in retirement.
Another big difference is the fact that a 10 percent early distribution penalty generally applies to funds withdrawn from a traditional IRA before age 59½. This penalty is in addition to income taxes that must also be paid at this time. However, Roth IRA contributions (not earnings) can be withdrawn penalty- and tax-free at any age if the account has been open for at least five years. In addition, Roth IRAs are not subject to required minimum distributions (RMDs) when you reach 70½ years old like traditional IRAs are.
If you make too much money, however, you cannot open or contribute to a Roth IRA. The Roth IRA eligibility limits in 2016 are modified adjusted gross income (MAGI) in excess of $132,000 (if you are single) or $194,000 (if you are a married couple filing jointly). If your MAGI this year is between $117,000 to $132,000 (if you’re single) or $184,000 to $194,000 (if you’re a married couple filing jointly), you can make a partial Roth IRA contribution.
The 2016 annual contribution limit for IRAs (both traditional and Roth combined) is $5,500, or $6,500 if you are 50 years of age or older. So if you are 50 years old, you can contribute $3,250 to a Roth IRA and $3,250 to a traditional IRA this year if you want to utilize both types of IRAs, and your spouse can do the same thing with separate traditional and Roth IRAs.
401(k)s: The Most Popular Employer-Sponsored Plan
401(k) plans first became widespread in the 1980s when many companies started replacing defined benefit pension plans with defined contribution plans that are funded primarily by employees, not employers. They are now the most popular employer-sponsored retirement plan in the U.S. In fact, the term “401(k)” has almost become synonymous with retirement savings.
401(k)s are established by businesses for the benefit of their employees, who make tax-deductible contributions (or salary deferrals, as they are referred to) into their individual 401(k) accounts. Each pay period, a percentage of your salary will be deducted from your pay and automatically contributed into your account.
Just like IRAs, 401(k)s come in two flavors: traditional and Roth. Traditional 401(k) contributions are made on a pre-tax basis — or in other words, the money is taken out of your pay before it is taxed. This not only lowers your current taxable income, but it allows earnings to grow without taxation, with taxes paid at ordinary income tax rates when distributions are taken during retirement. Also like traditional IRAs, withdrawals from traditional 401(k)s before age 59½ may be subject to a 10 percent early distribution penalty, and RMDs must begin no later than age 70½.
Roth 401(k)s enable high earners who cannot open and fund Roth IRAs to benefit from the unique Roth tax benefits. Like Roth IRA contributions, Roth 401(k) contributions are made on an after-tax basis, so you will receive no current benefit. However, investment earnings within the Roth 401(k) grow tax-free and fund withdrawals are also untaxed after age 59½ if the account has been open for five years or longer.
Many, but not all, businesses choose to match their employees’ 401(k) contributions at some percentage, like 50 cents for each dollar you contribute, for example. This is one of the biggest benefits of 401(k) plans for some employees — an employer match is the equivalent of a guaranteed, no-risk investment return. Note that employer matches to Roth 401(k)s are made with pre-tax dollars and accumulate in a separate account that will be taxed as ordinary income at withdrawal. They may also be subject to vesting rules that restrict your ability to keep the money unless you work for the company for a certain number of years.
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