Retirement funds, demystified
Wednesday, 12 September 2018
401(k), IRA, Roth IRA. When you're saving for retirement, there are so many choices. It can be challenging to determine which retirement fund—or combination of funds—is the right fit for you and your money.
Start by learning the distinctive features of each type of plan.
How it works: A 401(k) plan is a long-term retirement savings account sponsored by an employer for its employees. It allows employers to help their employees save for retirement while reducing taxable income, and workers can choose to deposit part of their earnings into a 401(k) account and not pay income tax on it until they withdraw the money in retirement.
Who's eligible: Employees who work at a company that offers a 401(k) plan are eligible to participate. Some companies may require you to reach a certain length of service before participating in the plan.
Pros: The interest you earn on money in a 401(k) account is never taxed before the funds are withdrawn. Also, employers often match contributions that workers make, providing "free" money for retirement.
Cons: The 401(k) plan is typically administered by the employer, and in some cases, employers have weighted the plans too heavily in their own company's stock. If the company's stock plummets, value in the 401(k) plan plummets with it. However, in a participant-directed plan, employees can choose from different kinds of investment options.
To check out your company's plan, visit Brightscope.com, the industry's most comprehensive database of 401(k) performance. The site assigns a simple numerical rating to 35,000 plans, based on audit reports that all plans file with the U.S. Department of Labor, as well as other data sources. The scores are available to investors for free.
Contributions: Employees may elect to make tax-deferred contributions to their 401(k) plans of up to $18,500 in 2018. Those who are over 50 can contribute an additional $6,000 to traditional and safe harbor 401(k) plans in 2018.
How it works: A 403(b) plan, also called a tax-sheltered annuity, is a retirement plan similar to a 401(k), offered by public schools and some nonprofit organizations. Like a 401(k), employees can save for retirement by contributing to individual 403(b) accounts, and employers can also contribute to employees' accounts.
Who's eligible: Employees who work at public schools or nonprofit organizations that offer a 403(b) plan are eligible to participate.
Pros: These plans offer flexible, tax-deferred contribution options for participants and the opportunity to take optional loans and hardship distributions from the plan.
Cons: Investment options in a 403(b) plan, like a 401(k) plan, are limited to those selected by the employer.
Contributions: Like a 401(k), the most an employee can contribute to a 403(b) account out of salary is $18,500 in 2018. Employees who are age 50 or over at the end of the calendar year can contribute an additional $6,000 in 2018.
Traditional IRA and SEP IRA
How it works: An IRA, or individual retirement account, is a savings account with major tax breaks. In most cases, IRAs are accounts that you open personally—as opposed to a 401(k), which is sponsored by your employer. Inside your IRA account, you can keep various investments such as stocks, bonds, and mutual funds. A SEP (Simplified Employee Pension) IRA is a type of IRA that is available to small business owners or self-employed individuals and offers higher contribution limits than a traditional IRA.
Who's eligible: Anyone who is younger than 70 ½ and has earned income can open an IRA. And any business owner with at least one employee, or anyone with income from freelance or contract work is eligible to open a SEP IRA.
Pros: When you deposit funds into an IRA, it is a pretax contribution, so the money grows tax deferred. And with your IRA, you can invest in practically any asset.
Cons: When you reach age 70 ½, you're required to begin taking mandatory withdrawals from your IRA, and those withdrawals are taxable. In addition, there's a 10 percent penalty on early withdrawals made before age 59 ½.
Contributions: In 2018, the maximum you can contribute to all of your Roth and traditional IRAs combined is $5,500 ($6,500 if you're age 50 or older), or your taxable compensation for the year, whichever is smaller. Self-employed business owners with a SEP IRA can contribute 25 percent of his or her net income, up to $55,000 for 2018.
How it works: Established by the Taxpayer Relief Act of 1997, a Roth IRA is a retirement savings plan that allows a tax reduction for retirement savers. The biggest difference from a traditional IRA is that funds are placed in a Roth IRA after taxes have been paid, so no taxes are due upon withdrawal.
Who's eligible:To open a Roth IRA, you must have earned income less than $120,000 if single or $189,000 if married and filing jointly in 2018. You can't deposit money into a Roth IRA once your income reaches $135,000 if single or $199,000 if married and filing jointly.
Pros: A Roth IRA offers tax-free withdrawals, and through the Roth IRA, you can invest in virtually any asset. Also, there are no mandatory withdrawals and no penalties for early withdrawals if the money is used to fund higher education, the first-time purchase of a house, or expenses related to death or disability.
Cons: Contributions are made after taxes are paid, and there is a 10 percent penalty on withdrawals made before age 59 ½.
Contributions: For 2018, the maximum you can contribute to all of your Roth and traditional IRAs, combined is the smaller of $5,500 ($6,500 if you're age 50 or older), or your taxable compensation for the year.
Employer contribution plans
How it works: Profit-sharing plans, defined benefit plans, employee stock ownership plans (ESOP), and money purchase plans are retirement savings plans organized, contributed to, and administered by employers. Some include optional employee contributions.
Who's eligible: To be eligible for a profit-sharing plan, defined benefit plan, money purchase plan or ESOP, you must be an employee of a company that offers one of these plans.
Pros: Each of these plans represent money contributed by an employer for the employee's retirement benefit, so it's "free" money to the employee.
Cons: Employees have no control over how the money is invested in most cases.
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