When it comes to retirement, we’re all looking for the best (or fastest) way to get there. Even if you’re a workaholic who can’t imagine ever being retired, the freedom that can come from retirement can mean only saying “yes” to the things that you really want to do without having to take on the less interesting tasks. But these days retirement planning can be challenging at best. Where pensions used to be the standard structure, we now have a hundred flavors of retirement savings accounts. Today we’re breaking down some of the most common retirement investment vehicles to make it easier for you to determine where you should funnel your money.
The Traditional and Roth 401(k)
Let’s start with the most common retirement savings option: the 401(k). A 401(k) is essentially an retirement account that is provided by your employer. Your employer is not necessarily required to contribute to your plan or match your contributions into a 401(k) plan, but many do. As a result, this is often the first place you should invest for retirement so that you are able to take advantage of the free matching that your employer is offering.
When does it make sense to choose a Roth 401(k) over a traditional 401(k)?
Often I hear that Roth 401(k)s are superior to traditional 401(k)s, but that is not necessarily accurate. A Roth plan allows for your wages to be taxed prior to contribution so that when you ultimately withdraw the funds from your Roth account, it will not be taxed at that future date. On the other hand, a traditional plan would allow your wages to be contributed pre-tax, but your contribution as well as any earnings would ultimately be taxed at the time you withdraw funds from your account. Determining which is best for you can be a bit tricky because you will have to predict what your retirement will look like and try to estimate whether you will be in a higher or lower tax bracket. If you are making a lot more money right now than you plan to withdraw annually during retirement, a Roth 401(k) MAY NOT make sense for you since your tax rate should be much lower in the future. Otherwise, a Roth 401(k) will generally be more beneficial from a tax savings perspective since the earnings are generally tax free.
Other things to consider include contribution limits and distribution criteria. Your annual contribution limits for these plans is generally $18,000 in aggregate. That doesn’t include the amount your employer contributes on your behalf, but rather, just the amount that you choose to contribute. If you are over the age of 50 you also may qualify for catch-up contributions of $6,000 per year, but note that these limits apply to 2017 and may change next year as they are indexed for inflation.
As far as withdrawals go, the retirement age on these accounts is typically 59 ½ years old. At that point you would be able to withdraw funds without a penalty being applied to your withdrawal. Prior to age 59 ½, a withdrawal may be subject not only to tax, but also a 10% penalty unless your distribution qualifies under the plan guidelines as a hardship withdrawal.
Just as a side note: If you work for a non-profit organization or a governmental organization, your plan may be called a 403(b) or a 457(b) respectively. While, they are similar in how they allow you to save for retirement, they may, have their own unique requirements and limitations.
Individual Retirement Accounts (IRAs)
Individual Retirement Accounts or IRAs are another great tool for retirement saving that anyone can invest in regardless of your employment status since they are not employer sponsored plans. You can open one through nearly any investment company such as Vanguard, Fidelity, Betterment, etc. They can still be traditional or Roth in nature, allowing for pre-tax or post-tax contributions respectively, however, there are some differences as far as contribution limitations go.
Here’s a really helpful chart from the IRS that compares the difference between Roth 401(k)s, traditional 401(k)s and Roth IRAs.
As far as traditional IRAs are concerned, the contribution limitation is the same as that for the Roth IRA though there are several exceptions to these contribution limitations including one for married couples where one spouse does not work. Additionally, while you can contribute to a 401(k) plan and an IRA plan, your tax-deduction might be limited for your IRA if you or your spouse participates in a work sponsored plan. If you think one of these exceptions might apply to you, find a CPA you trust who can help you work through the calculation.
Pensions vary from from 401(k)s and IRAs because you are guaranteed a specific payout as opposed to contributing a specific amount and being guaranteed only what the market yields. Instead, your employer is on the hook for making up the difference if the market doesn’t pay out what they were expecting. In this way, it can be a lot more valuable because it is income you can count on… for the most part. While your pension is most likely secure and can be factored into how much you will receive during retirement, you also should know that some pensions are more secure than others. If you have a pension from a private-sector employer, they are required to carry insurance via The Pension Benefit Guarantee Corporation (PBGC) which is a U.S. government agency. It essentially guarantees that if that company defaults on their promised pension to you, the PBGC will step in and pay you on their behalf up to a certain amount. As of 2015 you were guaranteed the lessor of your promised pension payouts or approximately $60,000 per year.
Unfortunately, no such insurance is offered for Federal, State and Local government plans, so those pensions are technically a little bit riskier, though the idea of a default on those pensions would have such a ripple effect through our economy that these governmental bodies have every motivation to ensure that their pensions are fully paid out in a timely fashion.
Social security is another source of retirement income that should be factored into your planning. To learn more about your social security benefits, check out this article.
In general when you’re investing for retirement, take advantage of employer sponsored plans first. The pension is the ultimate standard if you’re lucky enough to have an employer that offers one. 401(k)s should be your second choice especially where matching is offered. Lastly, IRAs can be a great tool for retirement saving if the first two are not options for you.
Written By: Lindsay Dell Cook
Lindsay Dell Cook is a CPA, finance writer, and founder of Budget Babble. She lives in Philadelphia with her uber supportive husband and adorable daughter. When she's not working, she enjoys spending time with her family, taking their lovable mutt for walks, or reading a good book while buried under a pile of cats.