You want to start building your nest egg but don’t know which type of retirement savings account to choose. Sound familiar? Settling for the 401(k) plan offered by your employer may seem like the most logical choice. But it may be worthwhile to explore traditional and Roth IRAs as well.
Read on to learn about key factors you should consider before making a decision.
Which option is best?
It’s a matter of personal preference. But the most important goal is maximizing your dollar. Here are some useful tips to help you decide:
Start with Your 401(k)
Does your employer match contributions made to your 401(k) plan?
You want to take advantage to earn a 100 percent return on your money without waiting for the power of compounding interest to work in your favor. But if you don’t contribute to your 401(k) and the employer offers a match, you’ll be leaving free money on the table.
In most instances, your employer will match up to a certain percentage of your gross salary, but not above the allowable limit. Or, they may commit to matching a set amount.
Beyond matching contributions, another major benefit of starting with your 401(k) is the ability to borrow against the funds. Even better, most 401(k) retirement plans allow you to do so without spending a fortune on penalties and interest. But, premature distributions from IRAs are subject to an early withdrawal penalty and taxation.
Unable to contribute up to the amount your employer will match? No worries. Do what you can. But if you’ve hit the contribution limit for the year, move on to a self-directed IRA.
Move on to Your Traditional IRA
Quick note: If your employer doesn’t offer a 401(k), you’ll want to start here.
Otherwise, once you’ve contributed the maximum amount to your 401(k) that your employer will match, the next stop is a traditional IRA (individual retirement account). If you’re fortunate enough to reach the maximum contribution limit for IRAs, you can pick up where you left off with your 401(k).
Consider a Roth IRA (If Needed)
Is a Roth IRA worth considering? It depends. It has a different set of tax advantages. If you meet the income criteria, a Roth IRA may be a good fit if you expect to be in a higher tax bracket at retirement and would rather save on income taxes now.
If you can’t decide between a traditional and Roth IRA, you could always open both to give yourself another withdrawal option at retirement.
But you should work on meeting the 401(k) employer match to claim the “free” money.
Bonus Tip: Don’t Place All Your Eggs in One Basket
You may want to focus on the employer-sponsored plan over the self-directed plan (or vice-versa). But ideally, you want to contribute to both if you have the means to do so to beef up your nest egg.
401(k) vs. Traditional or Roth IRA
To decide on the best strategy for your financial situation, you should have a general understanding of how these retirement accounts work.
Overview of 401(k) Plans
If you have a 401(k) retirement account through your employer, you can contribute up to $18,000 annually. The IRS also permits catch-up contributions of an additional $6,000 per year if you’re 50 years of age or older. Refer to this resource guide from the IRS for more detailed guidance.
Contributions are pre-tax, so they will reduce your taxable income. Consequently, distributions, which must be taken once you reach 70 years of age, will be subject to taxation.
As mentioned earlier, another major perk of 401(k)s is the earning potential that can be derived from matching contributions if it’s a perk your employer offers.
To illustrate, assume your employer offers a 100 percent match on up to 6 percent of your annual pre-tax income. If you earn $75,000, their contributions will cap out at $4,500. And you’ll have to contribute at least this amount to receive the matching proceeds.
While 401(k) plans are commonplace for those working in corporations and offer many benefits, there a there isn’t always a ton of flexibility as you’re limited to investment options preselected by your employer. And plan administration fees tend to be a bit steeper.
Traditional IRA Overview
What if your employer doesn’t offer a 401(k) plan? Or maybe you have a 401(k) but want to diversify your nest egg? A traditional IRA may be a viable option.
The contribution limits of $6,000 (or $7,000 for catch-up contributions if you’re 50 or older) are significantly lower than that of 401(k) plans. But this type of individual retirement account generally has lower administrative fees and affords you more flexible investment options. Plus, contributions are pretax, reducing your taxable income.
Unfortunately, a portion of your contributions may not be deductible if either you or your spouse have accounts through your employer or are in a higher income bracket.
Roth IRA Overview
Roth IRAs are very similar to traditional IRAs, but a key difference is that contributions are post-tax. This means they have no impact on your taxable income. However, distributions can be taken at any time and won’t be subject to taxation. This could be beneficial if you find yourself in a higher tax bracket at retirement.
You should also know that there are income limits. Only individuals with income of $129,000 or less ($204,000 or less if married filing jointly) can contribute the maximum amount to a Roth IRA.
Individuals with earnings between $118,000 and $132,999 ($186,000 to $195,999 if married filing jointly) can contribute a reduced amount. See IRS Publication 590-A to learn more about rules and contribution limits.
Taking Out a Loan Against Retirement Savings
Your future borrowing plans could be impacted by how your retirement savings are spread out across different account types. While IRAs allow for early withdrawals with penalties, they don’t have any loan options. A 401(k), on the other hand, allows for a loan option taken out of your savings.
Full disclosure: financial experts only recommend considering a 401(k) loan if you’re in a financial emergency and have no other options available to you, since you’ll lose compounding returns while repaying the loan. Still, it could be a better choice than a title loan or high-interest payday loan.
How a 401(k) Loan Works
You can avoid taxes when borrowing against your 401(k) amount. The withdrawal limit is the lesser or either $50,000 or 50% of your total assets in the account. Since you’re really taking out your own money rather than borrowing funds from a lender, you don’t have to worry about a credit check with a 401(k) loan. You also end up paying interest to yourself, not to a bank.
Repayment is simple and is spread out over a five-year period. Your payments are on an amortized schedule but that front-loaded interest goes directly into your 401(k) account, so you’re paying yourself. Another convenient factor is that you can schedule your payments to be automatically deducted from your paycheck and delivered straight into the account. They’ll be after-tax payments, though, unlike your original 401(k) contributions.
There’s no prepayment penalty, so you can knock out the debt ahead of schedule if you’re able to. Other fees are also minimal compared to most other loan options and are usually charged as just a reasonable administrative fee from your plan.
What happens if you leave your job with an open 401(k) loan?
There are many benefits to accessing a 401(k) loan. But if you choose to leave your job or get fired while you’re still in the middle of repaying your 401(k) loan, you’ll be faced with just two options.
The first is to repay the loan in full. How manageable this is for you depends on how much you’ve repaid already and how far into your repayment plan you are. It may not be out of the question if you’re close to wrapping up your loan payments. You generally get a 60 to 90 day grace period to give you time to make arrangements.
If, however, you can’t or don’t want to repay the loan balance when leaving your job, the remainder will be counted as an early distribution. You’ll have to pay taxes on the money and if you’re under 59 ½, you’ll also have to pay a 10% tax penalty. Those fees can quickly add up.
Exceptions for Purchasing a Home
If you want to use your 401(k) funds to help purchase your home, you can take advantage of a longer repayment period. The downside is that you can really start to lose the value of returns for a loan taken from your retirement account over such an extended period.
Compared to an IRA, however, you at least do receive more flexible borrowing options with the potential for being penalty-free.
You may not be able to decide whether to invest in an IRA or 401(k) overnight. Ultimately, you’ll have to do your research and decide which savings approach is the best fit to reach your retirement savings goals. And if you’re in a limbo or need more guidance, it’s best to consult a reputable financial advisor to help steer you in the right direction.