It’s never too early or too late to start planning for retirement. Of course, the sooner you begin the process, the easier it is to retire earlier and more comfortably. If you’re not sure where to start the preparations, you’re not alone; even the basics of retirement can be tough for most people to grasp.
It’s best to begin with the fundamentals and start by assessing your savings options, two of which are IRAs and 401(k)s. These two accounts are often confused, as they’re both designed for long-term savings and have tax benefits that save Americans money and encourage them to continue putting money away.
There are a number of differences between IRAs and 401(k)s that are crucial to understanding how to get the most out of whichever plan you choose:
IRA is an acronym that stands for “Individual Retirement Fund” and can be opened by anyone who wants one.
A 401(k) is employer-sponsored only, which means that if you don’t work for a company that offers you a 401(k), you won’t have access to one and may want to open up an IRA.
If you have a traditional 401(k), you’ll likely have the option of contributing to that account directly from your paycheck, before your income has a chance to be taxed. You will have to pay taxes on that money eventually, though, when you’re ready to use it for retirement. With a Roth 401(k), all contributions are made after taxes are deducted from your wages, meaning you’re paying your taxes up front and won’t have to pay them when it comes time to retire.
Taxes on IRA contributions work in much the same way. Amounts you contribute to traditional IRAs are tax deductible on both federal and state returns for the year they’re contributed. If you contribute to a Roth IRA, you won’t be able to deduct anything from your taxes, but you won’t be taxed on your earnings or withdrawals later on.
While owners of both IRAs and 401(k)s are commonly lawfully permitted to begin taking penalty-free distributions from their accounts at age 59 ½, owners of 401(k)s may be subject to different rules. Because 401(k)s are company sponsored, employers have the ultimate say over when distributions are given — especially if the account in questions belongs to someone who is still working for their company at the time. As mandated by the IRS, however, 401(k) distributions are required to begin on the April after the account owner turns 70 ½.
There’s a cap on how much you can contribute.
To keep up with inflation, the amount that can be contributed to 401(k)s and IRAs changes annually. For instance, while employees in 2013 were allowed to contribute $17,500 to their 401(k)s, they were permitted to contribute $18,000 in 2015.
The allowed yearly contributions for IRAs are roughly three times lower than for 401(k)s. Thus, in 2015 IRA holders could contribute only up to $5,500.
If your employer offers you a 401(k), it’s worth considering the benefits of holding and contributing to that account. If you’d prefer an IRA, talk to your bank and take a look at your options. Whichever savings plan you choose, opening your account and making your first contribution means you’ll be well on your way to financially securing your future.
If you’d like to explore more ways to prepare for retirement, contact Fundamental Finance Academy!