In the past you would rely on your company pension and Social Security to provide for your retirement plans. You worked for a long time, retired and lived off those two sources of income. Today, pensions have all but disappeared and the thought of relying on Social Security alone (it’s just not that much money) should make you nervous.
The road to a comfortable and secure retirement is to take charge of your savings yourself. It doesn’t help, of course, that there are so many options, offerings, and fine print that the decisions can be confusing, if not overwhelming. Read on to compare a trio of the most popular retirement savings accounts: the Big Three plans.
The 401(k) Plan
The employer-sponsored 401(k) is likely to be the best known to investors, simply because so many are likely to have encountered it at their workplaces. Of the Big Three retirement plans, the 401(k) offers you the opportunity to set aside the most money annually: $18,000 for 2017, plus an additional $6,000 if you are age 50 or over.
Your 401(k) contributions are made with pre-tax dollars: They reduce the amount of your gross income, which saves on taxes in the year you contribute to the 401(k). They grow tax-free within the account, too. Not to mention that many employers are restoring company matches to your contributions. That’s even more cash that will grow for your retirement years. There are a lot of positives to this retirement account.
However, there are some downsides. It’s your account, but the company owns the plan and chooses an administrator to offer different mutual funds within it. So, you have limited choice when it comes to investment options. You also incur management and administrative fees, along with investment fees that are hidden deep within the fine print of the financial statements—and there’s not much you can do about it unless you choose not to participate in the plan.
The Traditional IRA
IRA stands for Individual Retirement Account (or Individual Retirement Agreement). The Traditional IRA is similar to the 401(k} in that contributions are taken off the top of your gross income, reducing your income tax bill for that year; that your funds grow tax-deferred; and that you pay taxes only when funds are distributed from the account, which must start at a designated age.
An IRA is held entirely by you. Your company doesn’t own it, and your company won’t offer you a match on your investments. Since you own the account, you get to choose where it is held—your local bank, a major brokerage firm like Charles Schwab, or a mutual fund company like Vanguard. Because you choose the firm and the investments, you should be able to see how much the plan is costing you in management fees and fund expense ratios.
You can only invest $5,500 in a Traditional IRA in 2017; add $1,000 to that if you’re age 50 or over. There are also income limitations that can restrict how much you can invest and receive the full tax deduction. (If your income exceeds the threshold, you can still contribute, but your contribution may be partially or completely taxable).
The Roth IRA
Roth IRAs are the newest kids on the retirement-plans block. They are similar to Traditional IRAs in that you own the account, you choose the investments and you should be able to see the costs that are involved. There are income limitations to consider, as well.
However, the major difference is that your Roth IRA does not provide a tax deduction the year you make your contribution—you are investing after-tax funds. That means that while Traditional IRA or 401(k) funds will be taxed when they are withdrawn, Roth IRA distributions will not be—because you paid the income tax on them when you invested them.
At Least You’re Saving
How do you decide which of the Big Three retirement plans works best for you?
- If you anticipate your income tax rate being higher in the future then paying taxes today, as you do with the Roth IRA.lets you avoid paying higher taxes in retirement. (Also, Roth IRAs have no required minimum distributions (RMDs) at age 70½ so you don’t have to take money out of the account unless you want to.)
- If you anticipate your income tax rate dropping in retirement then paying tax today wouldn’t be as attractive as waiting until retirement to do so—as you would with the Traditional IRA and the 401(k). (Be aware that you will owe RMDs at age 70½, and they will increase your taxable income for that year.)
Regardless, one thing remains true: Investing for retirement in any of these three accounts is a step in the right direction.