IRAs and 401ks ExplainedMarch 30th, 2016
One of the biggest financial mistakes one can make is not saving enough for retirement. Unfortunately, this phenomenon is all too common, with up to 50% of Americans estimated to have no retirement savings at all.
There are multiple types of retirement plans, and you’ll want to choose one that best fits your needs. The most popular are traditional IRA, Roth IRA, rollover IRA, and 401k plans.
An Individual Retirement Account, or IRA is an independent investment account that allows you to save for retirement. A financial institution of your choosing sets it up, and the funds in it will accumulate tax-free, or tax-deferred.
There are many different IRAs, but the three most common types are:
- Traditional IRA-You contribute money towards your IRA at a tax-free or tax-deferred rate, until you decide to take the money out at retirement. You may also be able to deduct the money you put in your traditional IRA on your tax return.
- Roth IRA-Unlike traditional IRAs, Roth IRAs require you to pay taxes on the money you place in your retirement savings. The advantage is that your money may accumulate tax-free. You also may be able to take out the money, tax-free, at retirement.
- Rollover IRA-You may be able to “rollover” the money or assets from your employee retirement savings, to your IRA. There are many types of employee sponsored retirement plans, but the most popular is the 401k.
The 401(k) retirement plan refers to the Internal Revenue Service (IRS) tax code. It is the most common plan, and is usually provided by private sector employers. With a 401k, you place a portion of your monthly earnings in a retirement fund, and your employer will usually match your contribution up to a certain percentage.
Most employers will allow their employees to contribute up to 25 percent of their earnings. However, keep in mind that the IRS sets an annual limit on how much money you can contribute to your 401k. You’ll want to speak with your Human Resources representative, or a financial advisor, for more information.
There are also two main types of 401k plans your employer may offer. They are:
- Regular or Traditional 401k- Each month, a portion of your pre-tax income will be placed in your retirement fund. The employee won’t have to pay taxes on their contributions until the money is taken out upon retirement.
- Roth 401k-Unlike traditional 401k plans, money placed in your retirement fund each month will be taxed. However, you won’t have to pay taxes on your savings when you withdraw them. You’ll also only have to wait five years before you can withdraw funds from a Roth 401k plan.
You also won’t be able to withdraw funds until age 59 ½, or if you leave your place of employment after age 55. If you make a withdrawal before then, you’ll have to pay a 10 percent early withdrawal penalty, as well as income taxes.