You may be enrolled in a retirement plan at work, but do you know how it really works? Have you heard about other plans from friends and feel unsure whether you should be doing something different? Do you work for a small company that doesn’t offer a retirement plan?
In this column, you’ll learn the lingo, and how to distinguish among a Roth IRA, a traditional IRA, a 401(k), a Roth 401(k) and other retirement plans. You’ll also learn to contribute strategically if you have access to more than one retirement vehicle, and what to do if you don’t have access to retirement plans through work.
Why is this important?
Think of retirement accounts as a way to ensure that you won’t have to work when you don’t want to — or you can’t anymore. I’ve had clients ask me, “Why would I save for the future instead of enjoying the present?”
“Living for the moment” is great in theory, but you need to be able to do both. Having a good handle on where your money is going and how to automate it will keep you in control of both your present income and your savings for the future.
How much do I really need to be saving?
If you are someone who genuinely enjoys your career, and you think you’ll be working well into your 60s, then you won’t have to save as much as someone who has his or her heart set on retiring at 50.
A financial planner can help you evaluate exactly how much you need to be on track for your retirement goals. If you just want to get a good idea of whether you’re in the right ballpark, check out this Marketwatch Retirement Planner.
What’s the difference between a 401(k) and an IRA?
The 401(k) is a type of retirement plan available through employers for employees. In 2014, you can contribute $17,500 to a 401(k), 403(b), 457 or Thrift Savings Plan (or more if you’re over 50), and that’s just YOUR contribution. If you get a match on your retirement plan (lucky you!), then that could be in addition to your maximum of $17,500.
An IRA is an Individual Retirement Account, so it is not tied to an employer. The ability to deduct your IRA contribution (i.e. take the tax benefit) depends on whether you are eligible to contribute to a plan at work, and much how much income you will make, so always check what the current’s year’s limits are before you contribute.
The advantage of putting money into a 401(k) or an IRA is that you are reducing your taxable income now (although you will have to pay taxes when you take it out) AND you are making sure that you don’t have to work until you’re 100 (unless you want to).
What’s the difference between a Roth 401(k) and a regular 401(k)?
Recently, the Roth 401(k) has become more popular. The Roth 401(k) allows you to withdraw money tax free at retirement, as long as it has met all of the qualifications.
You can split your maximum contribution between a pre-tax 401(k) to get the tax break now, and the Roth 401(k) to get the tax benefits later. This is called tax diversification, and it allows you to have much more flexibility about which bucket you take your money out of in retirement.
What if I don’t have a retirement plan at work?
If you don’t have a retirement plan at work, your best bet is to contribute to either a Roth IRA or Traditional IRA, as long as your income falls into the ranges set by the I.R.S. If what you need to be saving (from the advice of a financial planner or from your own estimates) is more than the IRS plan limits allow, consider opening up a low-cost brokerage account and putting the additional savings into tax-efficient investments, like ETFs. If you don’t have a retirement plan because you work for yourself, you actually have more options, like a SEP or a SIMPLE for small businesses.
The best retirement plan for you is one where you can save what you need to be saving and get tax benefits — either now or later. I look forward to sharing other tips from the 5 Financial Must-Haves for Gen X and Gen Y, so stay tuned!