Planning for retirement might seem like a distant concern, especially when you’re busy juggling work, relationships, and the latest Netflix series. However, as we inch closer to that magical age when “9 to 5” becomes “sip and sunbathe,” it’s crucial to understand the financial tools that can make our golden years truly golden.
Two of the most popular retirement vehicles are the 401(k) and Individual Retirement Account (IRA). Both have their perks, quirks, and a bit of fine print that’s worth exploring. Let’s dive into each, demystifying these retirement plans in a way that’s easy to understand.
Understanding the basics: What are 401(k)s and IRAs?
Before we get into the nitty-gritty, let’s start with the basics. A 401(k) is an employer-sponsored retirement savings plan that allows you to invest part of your paycheck before taxes are taken out. An IRA, on the other hand, is an account you can set up independently to save for retirement with various tax advantages.
- 401(k): Offered by your employer, often with a company match (free money, anyone?).
- IRA: You open this one on your own, with more flexibility in terms of investments.
Think of a 401(k) as a group project where your boss contributes to your grade (retirement savings). An IRA is more of a solo assignment, giving you the freedom to choose your path but with more responsibility. According to the U.S. Bureau of Labor Statistics, as of 2022, about 68% of private industry workers had access to a 401(k) plan, but only 50% participated. When it comes to both 401(k)s and IRAs, it’s not an either-or situation. Both are key tools to use to plan for your retirement. But understanding who’s contributing (employer or just you) and the tax implications that apply is a must in order to maximize your retirement funds.
Tax benefits of a 401(k) vs. IRA
One of the most significant advantages of both 401(k)s and IRAs is the tax benefit. But how do you choose between a Traditional or Roth version of these plans since they both can significantly impact your future?! Let’s discuss:
- Traditional 401(k) and IRA: Contributions are tax-deductible, which means you reduce your taxable income today. However, you’ll pay taxes on withdrawals in retirement.
- Roth 401(k) and IRA: Contributions are made with after-tax dollars, but withdrawals in retirement are tax-free.
The choice between traditional or Roth depends on whether you think your tax rate will be higher now or in retirement. As of 2021, around 28% of 401(k) participants opted for a Roth 401(k). Knowing when and how you’ll be taxed can significantly impact your retirement savings. Weigh your current tax rate against your expected retirement tax rate, as well as your potential need for early future withdrawals, in order to make an informed decision.
Contribution limits of a 401(k) vs. IRA
Just like any good budget, there are limits to how much you can contribute to your 401(k) and IRA each year. And spoiler alert: the IRS is the one setting these boundaries.
- 401(k): For 2024, you can contribute up to $23,000 if you’re under 50 and an additional $7,500 as a catch-up contribution if you’re over 50.
- IRA: The annual contribution limit for 2024 is $7,000 if you’re under 50 and $8,000 if you’re over 50.
These limits are adjusted for inflation, so you might see these numbers creep up over time. In 2024, the average 401(k) balance for Americans aged 35-44 was around $91,000, and the median was $36,000. Maxing out your contributions, especially if your employer offers a match, is a smart move. Remember, every dollar you contribute today is one step closer to a comfortable retirement for you in the future.
Employer match (A.k.a., the closest thing to free money)
If there’s one thing we all love, it’s free stuff. And an employer match on your 401(k) contributions is about as close as you’ll get to free money in the financial world. But what is it, exactly? An employer might match your 401(k) contributions up to a certain percentage of your salary. For example, if they offer a 100% match on the first 5% of your salary, and you make $60,000, then contributing 5% means you add $3,000, and your employer will add $3,000 to your 401(k) for free. It’s like having your favorite coffee shop punch your loyalty card twice instead of once—it’s a no-brainer to take advantage of it! Contribute at least enough to your 401(k) to get the full employer match – your future self will thank you greatly!
Investment options: Choose your own adventure
Both 401(k)s and IRAs offer a variety of investment options, but the range and flexibility can vary significantly.
- 401(k): Typically offers a limited selection of mutual funds, target-date funds, and sometimes company stock.
- IRA: Provides a wider array of investment options, including stocks, bonds, ETFs, and even real estate in some cases.
Think of a 401(k) like a fixed menu at a restaurant—there are some great choices, but your options are limited. An IRA is more like a buffet—you get to pick and choose what suits your taste. In 2021, about 60% of 401(k) assets were held in mutual funds. When it comes to investing, diversification is key. Use your 401(k) for stable, long-term growth, and consider an IRA if you want more control and flexibility over your investments.
Withdrawal rules: Patience pays off
With retirement accounts, it’s important to remember the rules around withdrawals, or you could face some costly penalties.
- 401(k) and Traditional IRA: Withdrawals before age 59½ are generally subject to a 10% penalty plus income tax.
- Roth IRA: Contributions can be withdrawn tax-free at any time, but earnings or profits are subject to penalties if taken out early.
For example, trying to eat dessert before you have the main course—sure, you can do it, but you’ll probably regret it later. We all know that life can throw unexpected hurdles your way, but where possible, avoid early withdrawals so you keep your retirement on track. Let your money grow, and wait until retirement to enjoy the fruits of your labor.
Rolling over your accounts when changing jobs:
Changing jobs? Don’t forget about your 401(k)! Rolling over your 401(k) to an IRA or your new employer’s 401(k) plan can keep your retirement savings intact and avoid unnecessary taxes. According to Capitalize, in 2023, there were approximately 29.2 million forgotten 401(k) accounts. This is money someone has a rightful claim to, but is missing out on because they kept their accounts separate when moving.
- 401(k) Rollover: You can move your old 401(k) to a new employer’s plan or roll it over into an IRA.
- IRA Rollover: This can offer more investment options and easier management of your retirement funds.
Like transferring your phone number when you switch carriers—you don’t want to lose what you’ve built up just because you’re making a change. If you’ve moved jobs frequently, consider keeping your retirement savings consolidated by rolling over old accounts to avoid losing track of your hard-earned money.
Can you use a prenup to protect a 401(k) and IRA?
Yes, yes, yes! Don’t forget that prenup! Prenups can ensure your pre-marital assets, such as 401(k)s and IRAs, are protected in any situation life throws your way (divorce or death). In addition, don’t forget about protecting the appreciation of those funds. For example, let’s say you get married when you’re 34, and you have $50,000 in a 401(k). Let’s say that the account appreciates by another $50,000 by the time you divorce at 44 years old. You can ensure that both the principal amount and the appreciated amount are protected in a divorce.
Final thoughts on retirement accounts
Retirement planning doesn’t have to be complicated or overwhelming. By understanding the basics of 401(k)s and IRAs, you’re already ahead of the game. Whether you’re just starting your career or are closer to retirement, the choices you make today will set the stage for your future. And you’ll be oh so grateful to yourself that you did! Remember, the best time to start planning for retirement was yesterday, but the second-best time is now. So go ahead, channel your inner money expert, and make those financial moves that will keep you living your best life well into your golden years.
Laura Tynan is the founder of The Witch of Wall Street, a personal finance and investing community, where women are shown how to manage, multiply and manifest money, using simple strategies. Laura holds a BSc Hons in Finance, is a Chartered Accountant, and is certified in EFT Tapping, Breathwork, and RRT. She has been recognized by the Financial Times as a Top 20 Future Female Leader and by Yahoo! Finance as a Global Champion of Women in Business. She is a multi-award-winning speaker who has spoken at, and been featured in, Forbes. Laura hosts The Witch of Wall Street podcast and is the author of the personal finance and investing book for women, by the same name, which is available now on Amazon.
0 Comments