With the near extinction of employer-provided pension plans, it’s more important than ever to learn about common retirement options.
An IRA or 401k account can set you up for a comfortable retirement and are becoming more common in modern times. The reality of today is comprehensive employer-provided pension plans are a thing of the past. Gone are the days of clocking in nine to five for 30 years at the steel mill and retiring with full benefits. This model has become unsustainable for many industries, and as such, pension opportunities are quickly fading away. The loss of employer-provided pension plans is leaving many feeling lost and missing out on important benefits for their future. Thankfully, retirement options do still exist, such as a traditional or Roth IRA or a 401k plan.
Depending on your situation, you may find one, two, or even all three types of accounts beneficial for your retirement. Properly managed, your accounts can grow to meet your needs. These plans can help carry you through retirement, and it’s more important than ever to learn about them and how they can help you prepare for the road ahead.
What is a Traditional or Roth IRA?
An IRA (individual retirement account) allows someone to independently invest in their retirement, free from any employer. An IRA comes in two styles—traditional or Roth—both with their own advantages. A traditional IRA allows annual contributions of $5,500 a year, and an additional $1,000 in “catch-up” contributions for those over the age of 50. A Roth IRA has the same contribution limits as a traditional account; they are similar in that regard. One of the differences, though, is how they are taxed. Contributions and earnings are not taxed with a traditional IRA: only when funds are withdrawn will they be taxed. With a Roth IRA, your contributions will be taxed, but withdrawals will not.
Although a gamble, a Roth IRA can offer an advantage for younger people earning less now but who are expecting to be in a higher tax bracket in their future. It’s suggested that someone expecting to be in the same or a lower tax bracket should go with a traditional IRA to reap the most benefit.
An IRA is an investment account that you can manage yourself with proper knowledge, or you can work with your financial institution to manage it for you. Some of the investment choices are:
- individual securities
This allows for a wide range of options to tailor a custom plan for each strategy. Stocks and bonds can offer higher growth but at potentially greater risk. The market has an overall upward trend in spite of frequent volatility, so it’s suggested that shorter term plans focus more on less erratic investments.
A smart investor can earn great returns on their investments if properly managed and an IRA will allow that. It can also backfire, so a loss should be prepared for in the worst-case scenario. Of course, if you’re the more slow and steady type, safer but slower investments are always an option.
What is a 401k?
Even though employer-provided pensions are practically extinct, your employer may offer a 401k. The most common type of 401k is employer-sponsored with personal contributions up to a certain percent being matched by the employer. As of 2018, the annual contribution limit to a 401k is capped at $18,500. Contributions are taken from gross income, effectively providing some tax relief.
Any growth to a 401k account is tax free. Taxes are only taken out when withdrawals are made at the same rate as standard income. Taxes aren’t all you’ll lose either. Depending on your age, when a withdrawal takes place you could be subject to additional penalties. Anyone under the age of 59 ½ will be responsible for a 10 percent early distribution penalty. Early withdrawal can also negate any potential tax benefits that could have been taken advantage of at a later date.
The biggest disadvantage of a 401k account has to be that it belongs to your employer. While you always retain ownership of funds, your employer manages the plan, which leaves you little room to tailor to your needs. Fees, stipulations, and legalese can make understanding your plan difficult and frustrating.
While a 401k offers great incentive and benefits, it carries a lot of conditions. Any time a change of employer or career is made, you will have to decide what to do with the funds in the account. If your account is new and under $5,000 you can be forced to take your money out of your plan when leaving the company. If available, the better option would be to leave the money in the old company’s account until you can move it to your new employer’s account. Another option is to rollover a 401k into an IRA, which can be beneficial depending on your situation.
IRA vs 401k, Which Is Right for You?
Both plans offer advantages over the other, but that’s okay because they are not mutually exclusive. IRA and 401k plans can be utilized together to maximize retirement contributions. It’s generally suggested that if a 401k plan is made available through an employer, that it’s utilized to the fullest before making contributions to an IRA. The most tax benefit can be gained through thorough and efficient management of your 401k. Always take advantage of a 401k and maximize contribution matching if offered through the employer; it can offer a major edge.
If you’re maxing out contributions to an employer offered 401k plan and are still looking to invest, an IRA could be your next step. It’s advised to place additional investments into a traditional IRA if you don’t expect to move up tax brackets. A traditional IRA allows you to contribute tax-free, but taxes will be taken out when withdrawals are made. If you expect to be in a higher tax bracket when the IRA is accessed, a Roth IRA is advised. A Roth IRA will be taxed at the time the contribution is made, allowing you to withdraw without the worry of paying tax on the amount withdrawn. If contributions were made at a lower tax bracket than the moment of withdrawal, you’re effectively gaining a tax incentive.
In terms of flexibility, an IRA allows more of it. A 401k is managed by your employer: they choose how much control is allowed over the investments. An IRA is managed by the individual, allowing for much more control over your investments. Greater control allowed by an IRA may appeal to more savvy investors. The greater contribution limit and frequent employer contribution match offered by 401k plans is extremely attractive for anyone looking to invest in their future and shouldn’t be ignored if available.
If your financial direction allows it, utilization of both IRA and 401k accounts is the best option. Maxing out contributions and choosing the right type of IRA can reap great benefits further down the road. Using both types of plans to the fullest allows for the smartest investment plan possible and is advised.
Pensions may be no more, but that doesn’t mean you have to work into your 80s to survive. It’s now a modern necessity to manage our own retirements, but it’s possible with the tools available. With smart investment into IRA and 401k plans, you can be confident in your retirement.