You probably understand the importance of saving for retirement. However, what may not be as clear is which type of investment account, 401(k), IRA or Roth IRA, is best for you. Before deciding , it is important to know the difference between the three.
A 401(k) is offered by your employer, and in some cases, the company may even match a portion of your contributions. Any contributions you make to your 401(k) account are taken out of your check before income taxes. Since taxes are not deducted when you make the investment, you will have to pay taxes when you begin withdrawing money from your 401(k). The benefit of paying taxes at a later date is that you will likely be in a lower income bracket after retirement, so you will pay a lower tax rate on these earnings.
Currently, you can contribute up to $18,000 each year to your 401(k) if you are under 50, and $24,000 per year if you are 50 or older. Combined, you and your employer can donate up to $54,000 a year, or $60,000 if you are 50 or older.
There are a number of benefits to a 401(k) account. You can save money on your taxes since your contributions will not count toward your annual income. Also, many employers will match a portion of your contributions, which equates to free money for your retirement. Finally, since the money is taken out of your paycheck, you will be less tempted to spend it.
Your employer may offer other retirement plans, such as a 403(b) or 457. These work like a 401(k), but they are named differently as they fall under different classifications for the IRS. A 403(b), for example, is offered to employees of tax-exempt organizations, such as public school employees.
Unlike a 401(k), an IRA (individual retirement account) is not offered through your employer. If you are under the age of 70 1/2, you can work with an investment firm to open an IRA. Like a 401(k), you will make contributions to your IRA pre-tax, which means you will not pay taxes on this income until you make withdrawals after retirement.
There are limits to the amount you can contribute to your IRA. You can contribute $5,500 each year, or $6,500 if you are 50 or older. The limit will not apply to rollover contributions or qualified reservist repayments.
You will need to work with an investment firm to set up a Roth IRA, which is named after its legislative sponsor, Senator William Roth. Your broker will help you choose your investment options, and you can directly deposit your contributions into your account. Unlike a 401(k) or traditional IRA, the funds will be deducted after you have paid income taxes.
You can withdraw funds from your Roth IRA once you have reached the age of 59 1/2 and have had the account for five years or more without paying taxes. Unlike a 401(k), you can also withdraw the funds without paying a penalty if you need the money for a down payment on a house or for your child’s education.
Like a traditional IRA, the annual contribution limits for a Roth IRA are $5,500 unless you are 50 or over, in which case the limits is $6,500. However, if you make more than $118,000, or $186,000 if you file jointly, you will not be able to contribute the full amount. Also, at $133,000, or $196,000 if you file jointly, you are ineligible for a Roth IRA.
The benefits of a Roth IRA are that when you do withdraw your money, you will not have to pay income taxes, as you already have. Additionally, you can withdraw your contributions at any time without penalty, though you cannot withdraw any earnings before the age of 59 without paying penalties. Finally, unlike a 401(k), you can choose your broker and have more control over your investment options.
In an ideal world, you would max out your contributions to a 401(k), IRA, and Roth IRA. If you cannot do that, prioritize your savings. If your employer matches your 401(k) contribution, you will want to contribute as much as they will match.