When our grandparents were in their working years, planning for retirement was a simple exercise. Their employers funded their pensions over the course of their careers. Then, when the time came to stop working, the pension provided for their needs for the rest of their lives. This system was secure and uncomplicated, but times have changed substantially over the course of just a few generations. Today’s workers are faced with a plethora of options when it comes to saving for retirement, and picking the right plan can be confusing.
Two of the most popular types of retirement plans are the 401(k) and the Roth individual retirement account (IRA). While both plans are intended to help you build your retirement nest egg, there are significant differences between them, and both have benefits and drawbacks. Take a look at the information below for more information about each type of account:
The 401(k), named for section 401(k) of the US tax code, is an employer-sponsored retirement plan. This means that in order to participate in a 401(k), your employer must offer such a plan to its employees. If you want to start saving in a 401(k), you should contact your employer’s human resources department and see if this type of account is available. If so, you’ll have to fill out some paperwork, and the amount that you choose to contribute will be deducted from your paycheck automatically.
You should also see if your employer offers the additional benefit of matching your savings; this means that, up to a certain percentage of your income, your employer will contribute the same amount of money that you do to your account. So, for example, if your employer matches contributions up to 5%, if you save 5% of your income, your employer will add 5% to your account, too. Not all employers match their employees’ retirement funding, but if your company does, be sure to enroll in its 401(k) plan as soon as possible – this is essentially free money that you shouldn’t pass up.
are tax-deductible retirement savings accounts. This means that your contributions are taken out of your paycheck before you pay taxes on your income. This is beneficial because, to the IRS, it will “look” like you made less than you actually did, thereby lowering your taxable income. For example, if you elect to contribute $200 per paycheck to your 401(k), it’s as if you didn’t make that $200, as far as income taxes are concerned. You’ll pay taxes on your regular income, less that $200.
However, this doesn’t mean that you’re dodging income taxes on your 401(k) contributions. You’re just not going to pay them until many years later when you begin drawing on your income in retirement. A lot of people like this aspect of 401(k)s because they believe that their income (and, thus, their income taxes) will be lower in retirement than it is now, meaning that, over the course of their lifetime, they’re paying as little as possible in income tax.
There are several important rules and regulations to consider when it comes to 401(k)s:
You cannot withdraw your contributions before the age of 59½ ; if you do, you’ll have to pay income tax on the funds, plus a 10% penalty.
There is a limit to how much you can contribute annually to your 401(k) – for 2013, the limit is $17, 500.
You must begin drawing on your 401(k) by age 70½.
Roth IRAs, named after Senator William Roth, are individual retirement accounts, which means they are not employer-sponsored. Anyone with earned income can open a Roth IRA. If you want to start saving in a Roth IRA, you can do so online through most major banks and financial institutions; you can elect to have your contributions automatically deducted from your checking account on a schedule you arrange with your account provider.
Unlike a 401(k), Roth IRAs are not tax-deferred accounts. This is because when you contribute to a Roth IRA, you’ve already paid income taxes on those funds. For this reason, Roth IRAs don’t lower your taxable income. However, Roth IRAs do offer a significant tax advantage: The balance of your Roth IRA (the principle and interest) is able to be withdrawn tax-free when retirement rolls around. No matter how much money you end up with in the account, you won’t owe a dime in taxes on it. This makes Roth IRAs attractive to people who think that the tax code will be restructured in the future in such a way that income taxes will be higher than they are today. If this is the case, paying taxes today makes more sense.
Because Roth IRAs
use dollars that have already been taxed, there are fewer rules governing them. For example, unlike 401(k)s, there’s no age at which you must begin drawing on your Roth IRA. However, there are two important guidelines to keep in mind:
There is a limit to how much you can contribute to your Roth IRA; for 2013, the limit is $5,500.
Some people make too much money to contribute to a Roth IRA. Currently, single adults making more than $112,000 ($178,00 for couples) per year cannot use Roth IRAs.
Roth IRAs offer an additional benefit for those who value flexibility. If you want to withdraw the contributions (not the interest) you’ve made to your Roth IRA, you can do so at any time without having to pay taxes or a penalty.
Which Is Best for You?
So, how should you decide if a 401(k) or Roth IRA is right for you? It’s always an option to utilize both, but if you’d prefer to choose one of the other, consider a 401(k) if:
You prefer the convenience of a payroll deduction to contribute to your retirement account.
Your employer offers to match your savings – you should never give up free money!
You’d like to lower your taxable income now.
You believe that your income (and, therefore, income tax rate) will be lower in retirement than it is now, which means it’s sensible to defer paying taxes on your savings.
You make too much money to contribute to a Roth IRA.
On the other hand, you should consider a Roth IRA if:
Your employer doesn’t offer a 401(k).
You believe that income taxes will be higher in the future than they are now, which means it makes sense to pay taxes on your savings now.
You like the idea of your savings growing tax-free.
Editor's note: This story by Lindsay Konsko originally appeared on NerdWallet.
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You like the flexibility of being able to tap your contributions if you need to without paying taxes or penalties.
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