Saving for Retirement: 401ks, IRAs, and the Roth IRA Explained

Saving for retirement is a big deal. If you don’t believe me, ask anyone who is at or past retirement age and still working not because they want to, but because they must. The earlier you begin planning and saving for retirement, the better off you’ll be – and that means understanding and taking advantage of the various options out there for the choosing.

The main choices today are 401k defined contribution plans, traditional IRA retirement savings plans, and Roth IRA plans. Here, we’ll talk about each one and explain the pros and cons for each so you can make an informed decision.

401ks Explained

A 401k is what is called a defined contribution plan. In other words, it is a type of retirement savings plans that has a defined contribution from not only you, but your employer. Under this plan, a certain amount of pre tax dollars from your monthly pay is taken out and placed into your account. This money is matched by your employer up to a certain amount; together, the combined total is then used in a portfolio of investments so that the total value grows over time.

This is called a tax advantaged plan because you gain a tax benefit by using it. Because you get to use your money before taxes are automatically deducted, you can grow your assets a lot faster than you would if you had taxes taken out first. For example, growing $1,000 at 5% per year will accumulate more money faster than growing $700 at 5% per year. Taxes are taken out when you start withdrawing your money, but by that time, when you retire, it is possible that you will be in a lower tax bracket than what you are in now.

Your Annual Contribution Limit

There is a limit to how much you can contribute per year. For the 2012 tax year, you can contribute $17,000 per year from your pay. If you are 50 years of age or older, you can also contribute $5,500 in what is called a catch up contribution.

Your Employer’s Annual Contribution Limit

Between you and your employer, you can contribute a total of $50,000 in 2012. An employer can contribute up to $33,000 per year, or 100% of your salary (whichever is smaller), although the vast majority of employers do not max out contributions. Most provide for anywhere from 3% to 6% of whatever you contribute. At an average rate of 4.5%, that means they give $765 per year – which doesn’t seem very large. Every bit helps, of course – and that’s essentially free money.

For more information on contribution limits see:

How much can I contribute to my 401k per year?

When Can You Withdraw It?

Most people cannot withdraw from a 401k until the age of 59 ½. Otherwise, you will owe taxes and a 10% penalty on the amount. There are certain exceptions that allow for penalty free withdrawing, such as if you become disabled or take out a loan against your 401k and repay it with interest (to yourself).

More articles on withdrawing:

When do I have to take money out of my 401k?

Calculating 401k early withdrawal penalties

Can I get money out of my 401k without penalties?

Benefits and Drawbacks

The big benefit of a 401k is free money, a.k.a. employer contributions. Plus, you get to use pre tax dollars, which is always good. The disadvantage is that the plan is tied to your employer, and there are usually vesting requirements. Plus, there are costs associated with managing a 401k, namely because they are expensive to administer.

More information on 401ks:

Where can I put my 401k rollover to gain maximum returns?

How much will the tax be on cashing out a 401k?

Where should I invest my 401k?

Can you invest in both an ira and 401k at the same time? 

Is a Gold-Backed IRA Right for You?

Traditional IRAs Explained

Another common option is an individual retirement account, called an IRA. There are two types: traditional IRAs and Roth IRAs. I’ll start with the traditional one.

An IRA is a private retirement account that isn’t connected with an employer. This means you lose the employer matched contributions, but gain independence and flexibility. Otherwise, it is very similar to a 401k in theory and practice.

With an IRA, you contribute a certain amount of pre tax dollars into your account. This is then used to invest in a pool of assets. After a certain time – 59 ½ years of age in most cases – you can withdraw your money without paying a penalty.

These accounts are held by banks, financial institutions, or brokerages and generally allow investing in a wide variety of assets, such as stocks, bonds, mutual funds, certificates of deposits, money market accounts, and other classes. Your contributions are not taxed before you make them, and any contributions you make are tax deductible.

Your Annual Contribution Limit

For 2012, you can contribute up to $5,000 annually in your IRA. If you are 50 years of age or older, you can also give a $1,000 catch up contribution.

When Can You Withdraw It?

As with a 401k, you can withdraw money once you reach the age of 59 ½. Doing so before then is cause for a 10% penalty. There are exceptions, like your disability or death, using $10,000 for a first time home purchase for you or a family member, unreimbursed, out of pocket medical expenses, health insurance or higher education expenses, and annuity payments.

Benefits and Drawbacks

The biggest advantage of a traditional IRA is the fact that contributions are tax deductible. Drawbacks include the fact that you must withdraw after the age of 70 ½; otherwise, you are faced with penalties. Plus, there are eligibility requirements as far as income goes that determines how much you can contribute and if you can contribute at all. Finally, unlike with a 401k plan, you cannot take out a loan against your IRA.

Tax treatment of inherited ira accounts

Can I use an ira to pay off debts?

Do I pay taxes on a roth ira withdrawal of my original funds?

Can you use ira accounts as collateral?

Roth IRAs Explained

The other type of IRA is a Roth IRA. This is similar to a traditional IRA, with a few notable differences.

One major difference is that Roth IRA contributions are made with after tax dollars, meaning you already pay taxes before you put in money. If your tax rate is lower when you begin investing than it will be when you retire, that is a benefit; you’ll pay less in taxes than if you had to pay taxes when you withdraw money at retirement under a traditional IRA. This is because you do not have to pay taxes when you withdraw your money.

Another difference is that there are generally fewer restrictions on withdrawals, and earnings are not subject to tax. This is only if distributions are made after five years have passed, and you are at least 59 ½ years old (or if you meet an exception due to disability, death, medical payments, higher education expenses, etc.)

Drawbacks

Your taxes paid are not deductible, as with a traditional IRA. Plus, there are income eligibility limits that restrict how much you can contribute based on how much you make. Additionally, your contributions do not reduce your taxable adjusted gross income like a 401k or a traditional IRA.

In the end, you should consult with a qualified financial advisor to find the perfect plan for you. Learn about the various ins and outs and find a plan that fits your needs and financial situation. There’s also no rule that you have to pick just one; you can contribute to a 401k and an IRA if you so choose (and many do).

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