Update December 13, 2017
Are you ready for retirement?
If you’re an American, maybe not. According to a survey last year, 31% of non-retirees had no retirement savings.
Even if you are ready to start saving – and there are options out there for you to get started – it can get confusing. How much can you save? What sort of retirement account should you be using? Do you have to pay taxes on it?
The two most popular retirement accounts are 401(k)s and IRAs, and both are a good place to get started building your nest egg. Here are the main difference between the two so you know just where you should put your money.
401(k)s: one of your best workplace benefits
A 401(k) is a retirement product only available through your workplace. You probably know whether or not your employer offers it, but if not, ask whoever runs your benefits. Along with health insurance a 401(k) is one of the best benefits your employer can offer.
The main draw of a 401(k) is that your employer can match the contributions you make to the account. So if you contribute $50 and your employer matches, that’s $100 you have going into your account.
Your workplace may not match every dollar you put in, but even if you can get them to contribute something, that’s what’s known in the financial world as free money. Why would you pass that up? And even if you don’t get an employer match, saving is saving, and there are some great tax implications that we’ll talk about later.
You’re typically limited to where you can invest your money – your employer will have a handful of funds picked out where you can put your cash – but they’re legally required to vet and be transparent about options and fees, so the choices you have there might be better than what you’d pick on your own with an IRA.
There’s an $18,000 annual limit to the contributions you can make to your 401(k), and that gets bumped up to $24,000 for people over the age of 50 so they can invest a little more as they near retirement. Note that those are 2016 numbers and they’re periodically updated, so if you’re reading this in the future or with the benefit of a time machine, check the IRS website to see what the current contribution limits are.
IRAs: saving on your own
Unlike a 401(k), which you get through work, anyone can sign up for an individual retirement account (IRA) and start contributing money right away. Since it’s not through your employer they won’t be matching any contributions, but you have a lot more options in terms of the types of funds you put your money into. Plus, when you leave a job with a 401(k), you have to figure out what you’re going to do with that investment; since an IRA is yours and not tied to your workplace, you don’t have to worry about that aspect.
One big drawback if you’re deciding which account to open: the contribution limits for an IRA are a lot lower than they are with a 401(k) – $5,500 a year in 2018, or $6,500 a year for people over 50.
Your eligibility for a Roth IRA is limited by how much money you make; the 2018 income limits are $120,000 and $189,000 for individual and joint filing, respectively, so if you make more than that you’ll either be limited in how much you can contribute, or be completely ineligible for an IRA altogether.
Similarly, if you have a traditional IRA (don’t worry – we’ll get to what this means in a minute), you may be limited in how much of your contribution total you can deduct from your taxes – it depends on your income and if you also have a 401(k) with your employer.
Why you need to save
You need to start saving for retirement because no one else is going to be doing it for you.
You might hear your parents or grandparents launch into a "Back in my day…" where they spent 40 years at a job, walking uphill in the snow both ways, and retiring with a cushy pension.
Guess what? That’s not happening today.
Pensions grow more rare by the day, so you can’t rely on them to help you retire. Might as well get started now, right? The best part is you can have a 401(k) and an IRA, so you can double your chances at a stable retirement.
Plus, if you start saving for retirement, it can mean big things for your taxes.
We mentioned traditional IRAs earlier; when it comes to retirement products, it’s important to know the difference between a traditional and a Roth account. Both 401(k)s and IRAs have traditional and Roth versions, and the real difference between the two types is that when you pay taxes depends on which type of account you choose.
Essentially, if you choose a traditional account, you’ll pay less in taxes. When it comes to 401(k), your contributions are pre-tax. That means, as an example, if you make $60,000 per year and you contribute $10,000, you’ll be taxed as if you made $50,000. With a traditional IRA, the amount you contribute can be included as a deduction when you’re filing taxes.
The catch is that, since you aren’t paying taxes on it now, you’ll pay taxes when you make withdrawals in retirement. That’s the tradeoff in the choice between traditional and Roth contributions: do you want to pay taxes now or later. Taxes are inevitable, folks. If you aren’t paying them now, you’re just delaying it.
Roth contributions aren’t exempt from taxes when you make them, but on the other hand you don’t have to pay taxes on withdrawals. That might not make a lot of sense to some people: if you are going to have to pay taxes eventually, is there really a difference?
The idea is that most people will make more money the further they continue into their career – and, by extension, end up in a higher tax bracket by the time they retire. Therefore, you’d rather your contributions be taxed now, in a lower tax bracket, and not have to worry about it when you’re older and likely paying higher taxes.
Most people think of Roth contributions as being associated with IRAs, but 401(k)s and other retirement products have Roth variants, too. Roth 401(k)s were introduced in 2006 and even though they’re getting more popular, only about 14% of people who have access to one are using it.
Even though 401(k)s and IRAs are the most popular retirement products, you might be eligible for some other types of accounts.
A 403(b), for example, is similar to a 401(k), but the only people eligible for it are "public education organizations, some non-profit employers (only Internal Revenue Code 501(c)(3) organizations), cooperative hospital service organizations, and self-employed ministers." A 457 plan is available for state or local government employees, as well as some tax-exempt organizations.
Of course you could always go the route of good old fashioned investing in stocks and mutual funds, or look into a myRA, a relatively new product offered by the U.S. government that’s a lot like a Roth IRA for people who don’t have access to a 401(k).
Regardless of what retirement product you use and what type of contributions you make, you need to do one thing: start saving for retirement right away. Even if you can only contribute a little bit, compound interest will help out and every dollar helps.
Image: Robson Hatsukami Morgan