Understanding retirement plans: 401(k)s, IRAs, and other options
Retirement planning can be an overwhelming task, but it's essential to secure your financial future. Understanding the different types of retirement plans available to you can help you determine the best path for your situation. While you can rely on a financial advisor to walk you through all of these things it can help to be familiar with your options before you step into that conversation.
In this article, we will discuss various retirement plans, including 401(k), IRA, and Roth IRA, and compare the pros and cons of each.
What is a 401(k)?
A 401(k) is an employer-sponsored retirement plan that allows employees to save for retirement while reducing their taxable income. With a 401(k), an employee can contribute a portion of their pre-tax income, and the contributions grow tax-free until withdrawal.
Employers may also match a percentage of an employee's contribution, providing additional savings for retirement. While your employer match does not impact your tax burden it can dramatically increase your overall 401(k) value if you are aggressively contributing and trying to hit your FI (financial independence) number as quickly as possible.
Example:
Let's say you earn $60,000 per year and contribute $5,000 to your 401(k) plan. Your taxable income for the year would be reduced by the amount you contributed, which means your taxable income would be $55,000 instead of $60,000.
By reducing your taxable income, you'll pay less in federal income tax. For example, if you're in the 22% tax bracket, the $5,000 you contribute to your 401(k) would save you $1,100 in federal income tax.
Contributing to a 401(k) plan reduces your taxable income, which means you pay less in federal income tax. This can make a significant impact on your overall tax bill and help you save more money for retirement.
What is an IRA?
An IRA, or Individual Retirement Account, is a personal savings account designed to help individuals save for retirement. With an IRA, you can invest in a variety of assets, such as stocks, bonds, and mutual funds, depending on your investment goals and risk tolerance. Unlike a 401(k), an IRA is not tied to an employer, and you can open and contribute to an IRA account independently.
Are there different types of IRA accounts?
Yes, there are several types of IRA accounts, including Traditional IRA, Roth IRA, SEP IRA, and SIMPLE IRA.
Traditional IRA
A Traditional IRA allows individuals to contribute pre-tax dollars and grow their investment tax-free until withdrawal during retirement. The contributions made to a Traditional IRA may also be tax-deductible, making it a popular choice for individuals who anticipate being in a lower tax bracket during retirement.
Roth IRA
A Roth IRA is another popular type of IRA, which allows individuals to contribute after-tax dollars, meaning that the money invested has already been taxed. The contributions made to a Roth IRA grow tax-free and can be withdrawn without penalty after age 59 1/2. This account is suitable for individuals who anticipate being in a higher tax bracket during retirement.
SEP IRA
A Simplified Employee Pension (SEP) IRA is an employer-sponsored retirement plan designed for small businesses and self-employed individuals. With a SEP IRA, employers can contribute up to 25% of their employee's salary, up to a maximum of $58,000, for the year 2021.
SIMPLE IRA
A Savings Incentive Match Plan for Employees (SIMPLE) IRA is also an employer-sponsored retirement plan for small businesses and self-employed individuals. Employers can choose to match employee contributions up to a certain percentage of their salary or make a fixed contribution of 2% of the employee's salary.
What are all the different types of retirement plans I can invest in?
Apart from 401(k) and IRA, there are several other types of retirement plans available, such as:
Defined Benefit Plan
A defined benefit plan is a traditional pension plan where employers guarantee a specific retirement benefit to their employees, based on their years of service and salary.
Cash Balance Plan
A cash balance plan is a type of defined benefit plan that credits a percentage of an employee's salary to their account each year. The account grows tax-free and can be withdrawn during retirement.
Profit-Sharing Plan
A profit-sharing plan is an employer-sponsored retirement plan that distributes a portion of the company's profits to its employees. The contributions made to a profit-sharing plan are tax-deductible and grow tax-free until withdrawal.
Keogh Plan
A Keogh plan is a type of retirement plan designed for self-employed individuals, allowing them to contribute up to 25% of their net income towards their retirement savings.
What are the pros and cons of a 401(k) vs an IRA?
401(k)
Pros:
Employers may match employee contributions, increasing your retirement savings.
You can contribute more to a 401(k) account than an IRA account, up to $19,500 for the year 2021.
The contributions made to a 401(k) account reduce your taxable income, lowering your tax bill.
Cons:
The investment options in a 401(k) account are limited to the choices provided by the employer.
Withdrawals before age 59 1/2 are subject to a 10% early withdrawal penalty, in addition to taxes.
IRA
Pros:
You have a broader range of investment options to choose from, giving you more control over your retirement savings.
Withdrawals from a Roth IRA account after age 59 1/2 are tax-free.
With a Traditional IRA, you may be able to deduct your contributions from your taxable income, reducing your tax bill.
Cons:
Contribution limits are lower than a 401(k) account, up to $6,000 for the year 2021, or $7,000 for individuals over age 50.
Contributions made to a Traditional IRA are tax-deductible but are taxed when withdrawn during retirement.
Roth IRA - More Details
A Roth IRA is an excellent retirement savings option for individuals who anticipate being in a higher tax bracket during retirement. While the contributions made to a Roth IRA are made with after-tax dollars, the money invested grows tax-free, and withdrawals during retirement are also tax-free.
Opening a Roth IRA is simple and can be done through a financial institution or brokerage firm. Individuals can contribute up to $6,000 per year to a Roth IRA, with an additional $1,000 catch-up contribution for individuals over 50 years of age.
To maximize the benefits of a Roth IRA, it's essential to start contributing early and consistently. Additionally, it's crucial to review and adjust your investment portfolio regularly to ensure that your investments align with your retirement goals.
Conclusion
Understanding the different types of retirement plans available to you is essential in making informed investment decisions. While there are various retirement plans, 401(k), IRA, and Roth IRA are some of the most popular options.
When deciding between a 401(k) and an IRA, it's essential to consider the investment options available, contribution limits, and tax implications. On the other hand, a Roth IRA is an excellent option for individuals who anticipate being in a higher tax bracket during retirement.
Investing in a retirement plan is a critical step toward securing your financial future. By understanding the different types of retirement plans available and their pros and cons, you can make informed decisions and choose the plan that best fits your retirement goals.