Many people begin to feel overwhelmed when they start thinking about saving for retirement. A large number of products exist, and it can sometimes be difficult to distinguish which are the most appropriate for any given situation. Becoming educated about each of the different products can be a challenge when individuals must consider where to put their money and which products have the greatest potential for high returns. However, it is important to understand the key difference between the most popular retirement savings products.
401(k) and 403(b) Retirement Plans
Workplace retirement plans tend to fall under the 401(k) or 403(b) umbrellas. Through these plans, employees can contribute pre-tax dollars to their retirement plan. However, these plans include a maximum annual contribution. Once individuals reach 50 or older, the maximum increases. When people withdraw funds from these accounts, they must pay relevant taxes and a penalty if it is not a qualified withdrawal. Individuals are limited in terms of the investment options made available through the plans.
Roth 401(k) and Roth IRA Retirement Accounts
Another popular option is the Roth 401(k). Employees may contribute to this plan on an after-tax basis, which allows their contributions to grow tax-free. In a Roth 401(k), similar contribution limits and penalties exist as with traditional 401(k) accounts.
In addition, people should understand the difference between a deductible IRA and a Roth IRA. Contributions to a deductible IRA may or may not be tax deductible. The ability to deduct the IRA contribution depends on one’s modified adjusted gross income, filing status, and whether or not one’s spouse can enroll in a company retirement account. While limitations on contributions exist, they are significantly lower than those of a 401(k). A Roth IRA resembles a Roth 401(k) with a lower contribution limit. However, income limits may also prevent some people from opening a Roth IRA.
A General Outline for Approaching Retirement Savings
While the following outline about how to save money for retirement can serve as a good basis, individuals should always consider what is best given their personal circumstances. The first step toward saving is the easiest and—most people would agree—the best course. This step involves contributing to a 401(k) with employer match to the fullest extent. Since an employee match is basically free money, individuals should take full advantage of this opportunity, if it is offered.
The next step depends in large part on one’s personal circumstances. Individuals who qualify for a Roth retirement account, whether it be an IRA or 401(k), should consider this option. First, people should look at tax rates when contributions are made and withdrawals are taken. If both of these rates are the same, then the Roth account does not provide much of an advantage in terms of saving for retirement. However, if the tax rate is lower for making a contribution than for withdrawing funds, then a Roth account can save considerably on tax expenses.
This approach assumes that the tax policy decades from now will resemble that in place today, although this is impossible to predict. As a general rule, people in lower federal tax brackets can benefit the most from Roth accounts since they are at greater risk of facing higher tax rates in retirement. People in higher tax brackets do not face this problem.
Examine 401(k) Investment Options
By maxing out the employer 401(k) match program, the vast majority of employees will not have reached the limit for 401(k) contributions. The next step for many people is to max out their 401(k) plan. Some financial planners will tell individuals to contribute first to an IRA because 401(k) plans tend to have high fees and to invest in expensive mutual funds. While this assumption may prove true, neither of these facts means that a 401(k) is necessarily a poor investment option.
Individuals are advised to spend some time looking at 401(k) investment opportunities to see if low-cost options exist. If the investment options seem to fit with their plan, then it is wise to contribute up to the limit. If individuals are not happy with the investment options available, then an IRA is often a better option.
With an IRA, individuals have complete control over their investments, and low-cost fund options exist. Making contributions to a Roth IRA or deductible IRA involves a bit more legwork than a 401(k), but once everything is set in place, individuals can make monthly contributions automatically from their bank accounts. Before opening an IRA account, individuals should conduct due diligence to ensure that the account is the best option for their needs.
What to Do with Any Leftover Retirement Savings
Since IRAs have relatively small contribution maximums, individuals may still need to reconsider a 401(k) if they previously chose not to invest and still have money to do so. Individuals can find investment options outside of a retirement account, which involves significantly more risk, or simply max out their 401(k) with the remaining funds.
The above is simply a basic framework for how to go about applying funds to a retirement account. Some individuals may choose to accept higher risk and avoid many of these products altogether, while other people may invest all of the funds they have budgeted for retirement into an employer 401(k) match program. However, the framework provides a smart approach to figuring out how to maximize savings and secure the most comfortable retirement.