Wednesday, September 21, 2016

Choosing Between a 401(k) and IRA

With the demise of traditional pension plans and the future of Social Security in doubt there has never been a more important time for individuals to seize the initiative of saving for their retirement. But with many different options to choose from, it is imperative that retirement money be invested wisely and with as many tax advantages as possible. 

Both 401(k) accounts and Individual Retirement Accounts (IRA) are important vehicles to save for retirement, but which to choose from? Here are some of the attributes of both 401(k) accounts and IRA's and how each can help you meet your retirement savings goals. 

Funding your 401(k) account through your employer is the perhaps the most important investment step that you can make. Not only do many companies offer to match your contributions to these accounts, but 401(k) accounts have the important characteristic of being tax deferred, meaning that all interest and growth of principal is not taxed until the monies are withdrawn. In addition, all contributions used to fund the account are made with pre-tax dollars.
Matching contributions typically are a percentage of the amount the employee contributes (for example 25%) or a percentage of annual salary (for example 3% of your annual salary is contributed to your account) with a cap at a certain amount (say $5,000). Meaning that if the employee contributes $10,000 to their 401(k) account for the year, the company will contribute $2,500 to the account as well. Or if your yearly income is $50,000, the company will contribute 3% of your salary, or $1,500. Read your companies' retirement plan carefully, as typically the company contribution will vest over several years of service. 

Contributions to a 401(k) are made with pre tax dollars, meaning that all monies are made before they are subject to federal, state, unemployment, and disability taxes. That means that you are able to contribute a higher amount because your gross earnings have not yet been taxed. 

In addition to their other beneficial qualities, 401(k) accounts are tax deferred, meaning that all earnings in these accounts are not subject to tax until they are withdrawn from the account. Any interest, dividend, or growth of your contributions are not taxed, and the magic of compounding interest allows for the amount in your account to grow rapidly. 

When faced with a decision, it will almost always benefit you to fund the account that is tax deferred. When you combine the tax deferred qualities of a 401(k) account, along with the ability to contribute pre-tax dollars and company matching amounts, 401(k) accounts should be one of your first investment choices. Once you have contributed the maximum amount to your 401(k) account, then it is time to consider other investment vehicles such as IRA's. 

There are two major types of IRA's, each with their own unique tax benefit. Contributions to Traditional IRA's reduce your taxes in the year you add money to the account (the maximum contribution for most folks in 2016 is $5,500). However, when you withdraw the funds from this account after retirement, all monies taken out are taxed. 

Roth IRA's do not generate a tax benefit in the year you make a contribution, so even though you may contribute $5,500 (the maximum amount for 2016), you won't get a tax benefit in that year. However upon retirement, all monies that are taken out are not taxed. Since the money is withdrawn tax free upon retirement, Roth IRA's thus have the potential to yield tremendous tax-free returns over long periods of time. 

Setting up a Traditional IRA or Roth IRA can be done at most banks, online brokerage houses, or mutual fund companies. Search around for the best deal and do your best not to pay account maintenance fees, or other costs, as these will slowly erode your yield over time. IRA's may contain any number of financial instruments including stocks, mutual funds, bonds, even real estate or precious metals.

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