With the economy in turmoil and social security in question many people have now taken their financial freedom into their own hands. With retirement being the biggest concern amongst people looking to live a better life we have compiled a quick tutorial hat will tell you the difference between your retirement choices:
401k
If you’re working a 9-5 a 401k is the first thing you should be investing in; a 401(k) is a retirement plan that allows a worker to save for retirement and not pay any taxes on the money that goes into the plan until later. This is called tax-deferment. This benefit allows you to earn interest on money that would have gone to the IRS and allows you to pay the taxes once you take the money out at retirement, which is currently at 59 1/2 years old. At retirement it is assumed that you will be earning less, which would put you in a lower tax bracket hence saving you more. The money that you invest into your 401(k) is also known as a “Contribution”. Your contributions into your 401(k) is never seen by you because as the employee, you elect to have a portion of your wages paid directly, or “deferred,” into your 401(k) account making the process painless. As an added bonus your employer can optionally choose to “match” part or all of your contributions by depositing additional amounts into your account.
Most 401(k)’s have pre-set options that you can choose from depending on your risk tolerance but consult with a financial advisor to get proper guidance on which options are good for you.
IRA
An IRA which stands for an Individual Retirement Account is very similar to a 401(k). In fact the only real difference is that a 401(k) is sponsored by your employer, while an IRA is sponsored solely by you (there are some exceptions to that rule but I’ll explain further below). In order to contribute to a 401(k) you have to have a company that participates in the program, but to contribute to an IRA the only stipulation is that you have earned income within that year. An IRA provides the same tax benefits as a 401(k), which includes tax-deferment and a tax-free option. The following are different types of IRA’s:
• Traditional IRA – a traditional IRA is the most common. Contributions are often tax-deductible which means that anything you contribute is deducted from your income and doesn’t require you to pay taxes until you withdraw. Just like the 401(k) your withdrawal at retirement is taxed as income at your current tax rate based on your tax bracket. All of the transactions and earnings have no tax implication as long as it is done within the IRA.
• Roth IRA – the contributions are made with after-tax dollars, which means that you cannot deduct the amount contributed from your income when you file your taxes. Any withdrawals that are made are tax-free, meaning you don’t have to pay any taxes on the principal or interest. Any transactions that you do within the IRA have no tax implication.
The easiest way to remember the two is that a traditional IRA gives you your tax break in the end – tax-deferred and a Roth IRA gives you the tax break up front – tax-free.
• SEP IRA – a SEP IRA is designed for a small business or self-employed person to make retirement contributions into a traditional IRA that he/she sets up in his/her employee’s name.
• SIMPLE IRA – a simple IRA is also set up by an employer and stands for a simplified employee pension plan that allows both the employer and employee to make contributions. This is exactly the same as a 401(k) except that a simple IRA has lower contribution limits.
A retirement account is the best way to save for the future and with it’s many tax benefits there’s no excuse to not invest in one. Make sure you do further research before deciding which option is right for you. Your banker should be the best person who can answer your retirement questions (if you don’t have a banker its time to switch banks).
