Monday, October 6, 2014

Money Monday: IRAs v. 401(k)

In last week's Money Monday post, we covered the basic definitions of Traditional IRAs, Roth IRAs and 401(k) plans. This week I thought it would be good to further examine the concepts of IRAs and 401(k) plans, to help promote an awareness of how each option might benefit you (and, in some cases, which option might provide a greater benefit than the other).
As we discussed previously, both 401(k) plans and Individual Retirement Accounts consist of contributions from pre-tax dollars. Basically, you are not required to pay taxes on the money contributed to the account (or any interest/capital gains) until you begin receiving distributions. The contributions to these accounts also decrease your taxable income…meaning Uncle Sam gets less of your money in the meantime.
No matter how young or old you may be, taking steps to prepare for retirement is a smart thing to do. When evaluating options for retirement investments, these two types of plans stand out most.

So, in the battle of 401(k) v. IRA…which is better?
To get the answer that best fits you, we need to make sure you understand what both options are.

It should be relatively easy to determine the personal value of signing onto a employer's 401(k) policy. If the company partially contributes (or matches employee contributions), this could be a very beneficial (and lucrative) option.

Pros/benefits of utilizing a employer-sponsored 401(k) for your retirement plan:
-- Emergency withdrawals: In the event of an emergency or
financial crisis, you can borrow from your 401(k)
-- Matching: Employers are allowed to match up to 6% of your salary
(this is basically free money from your employer!)
-- Deferred taxes: No tax on interest or capital gains until time of distribution
-- High contribution limits: As of 2011, account owners are allowed to contribute up to $17,000 per year into their 401(k) if they are age 49 or younger, up to $22,500 if they are age 50 or older.
-- Income tax deduction during year of contribution: The same year you contribute to your 401(k) account, account holders can deduct the amount placed into their 401(k) from their net income.

Cons/flaws of 401(k) plans:
-- Waiting periods: Often there is a waiting period before employees can initiate a 401(k) plan with an employer, varying anywhere from six months up to one year.
-- Limited flexibility: Plans offered by a large percentage of employers can be noticeably short on options. Make sure you have a good understanding of where the funds are being invested.
-- IRA deductibles excluded: Plan holders that contribute to their 401(k) can reduce (and even, in some cases, eliminate) the income tax deductions allotted for an IRA
-- Taxable income upon withdrawal: When you start withdrawing money, it is taxed as additional income. There are also penalties for early withdrawals, with taxation up to 20% plus a 10% penalty if you withdrawal before age 59 1/2.
-- Required withdrawals at age 70 1/2: Plan holders must be receiving distributions by age 70 1/2. And if you're still working, you may be subjected to a higher tax rate than if you were retired.

Traditional IRA

An IRA is a method of saving money for retirement that is not an employee-sponsored 401(k) plan. Many who are self-employed or those who work for small businesses may choose this form of retirement planning. IRAs also have their own pros and cons to weigh.

Pros/benefits of a Traditional IRA:

-- Tax-deferred: Funds go into a tax-deferred retirement plan account and can be set up at any time.

-- Easy, cheap to start: Plan holders basically set up their own IRAs, often with little or no help from any kind of financial planner. This saves not only time but cost.

-- More investing options: While IRA holders may not have employers who match their contribution, they frequently have more investment options (including stocks, bonds, mutual funds and CDs).

-- More flexible allocation: While tracking the performance of an IRA, holders who find an element of the account that is not performing as expected can change the allocation. This flexibility makes the IRA a top choice among serious investors.

-- Roth IRA option: The Roth is a popular choice for converting a traditional IRA. The difference between the two is that contributions to a Roth are made with post-tax dollars. Roth IRAs grow tax-free and offer tax-free income withdrawals at age 59 1/2. The catch is that you have to pay taxes on the amount you convert, as if it were ordinary income.

-- Tax deductions: Contributions to a traditional IRA can be claimed as a tax deduction, depending on the policyholder’s income tax bracket.

Cons/flaws of IRAs:

-- Limited contribution maximum: The holder may only deposit up to $5,000 if age 49 or younger; or $6,000 if age 50 or older.

-- Low contribution rate: IRAs have a low contribution rate. If you're starting an IRA retirement plan later in life, the contribution rate may not be enough.

-- Penalties for early withdrawal: Much like a 401(k) plan, there are penalties for early withdrawal.

-- Required withdrawals at age 70 1/2: Policyholders are also required to begin withdrawing money by 70 1/2 years of age.

In general, you should remember these two things when starting a personal retirement plan:
  • A 401(k) plan’s employer-matched contributions and higher contribution allowances can help your tax-deferred retirement savings grow more quickly.
  • An IRA’s variety of investment offerings can better provide the flexibility to diversify your portfolio.

Additionally, borrowing against an IRA is not permitted, but a 401(k) plan does allow for this. A 401(k) can even help to provide “emergency assistance” to help policyholders withdrawal as quickly and easily as possible when there are immediate needs for a household (i.e. car or home repairs), or in case of a financial crisis.
If your employer offers a 401(k), sign up for it. You can also open a traditional IRA on the side to maximize your retirement savings. Whenever possible, contribute as much as you can to the 401(k) first (which hopefully your employer will match) and then to the IRA. If you don’t have access to a 401(k), a traditional IRA is an excellent choice for retirement savings, offering tax-deferred growth.
If you have any concerns about your finances, by all means, see a consultant or advisor.
I can only provide so much information here, and it is all mean to inform (not determine).

Any experiences with 401(k) or IRA plans?
Send your thoughts to:

Happy Monday!
xxxx Alyssa Marie

No comments:

Post a Comment