The ABCs of pensions, IRAs, and 401(k)s
Monday, 4 May 2015
Retirement doesn't come cheap, especially given that life expectancy and the cost of living are on the rise.
Add in worries about the long-term viability of federal Social Security and Medicare programs—and the idea of a "comfortable retirement" may start to seem like a long shot. The good news is that you can face your golden years with a tidy nest egg —if you invest in a bit of strategic planning and a dedicated savings plan. Beginning in your 20s will give you a big head start, but it is never too late to map out a retirement plan. There are many ways to save for retirement—the best choice will depend on your specific employment situation:
Pensions: Quickly becoming a thing of the past
With traditional pension plans, companies reward employees for years of service with lifetime payments, made in either monthly payouts or a lump sum. Details vary, but basically the employer administers and funds the plan, and the employee has no say in how the funds are invested. Money you receive from a pension is taxed as income. Traditional pension plans are a dying breed and are usually limited to large companies, but some do still exist.
401(k) employer plans: fan favorite
By far the most popular retirement tool, a 401(k) is an employer-sponsored retirement plan. It allows you to automatically deduct a portion of your wages from your paycheck and contribute it to the plan, tax-free—an easy and painless way to save.
There is a yearly cap on contributions, which changes based on inflation. Check with the IRS website to verify the dollar amount of the cap. The IRS also allows a "catch-up" provision for those age 50 and above. Again, check with the IRS to determine if you're eligible to contribute more.
Some employers "match" their employees' 401(k) contributions, up to 6 percent of income (the limit allowed by the IRS). This is essentially "free" money and should not be taken for granted. If your employer contributes to your 401(k) plan, their contribution may be subject to a vesting period. This means that if you leave your job before a specified time, you won't receive your employers' share of the contribution. But don't worry, the amount you've contributed will always be yours—even if you leave your job.
Once you retire, your withdrawals will be taxed as income. You will be penalized (taxes due plus a 10 percent penalty) if you withdraw funds from your IRA before age 59 ½. However, you can use your account as collateral, should you need a loan before that time. You must start taking distributions (or payments) from your 401(k) by the time you turn 70 ½ or you will face penalties. The human resources employees at your job will be able to advise if a 401(k) is offered by your employer.
IRAs: gold medals for the self-employed
The second most common type of retirement savings account, Individual Retirement Accounts (IRAs), are generally considered to be the best option for the self-employed. IRAs come in several forms, but the most popular and common are "traditional" and "Roth" IRAs.
- Contributions to a traditional IRA are tax-deductible, depending on your income and tax bracket, although "phase out" levels exist.
- Payments, or "distributions," are taxed as income when you begin making withdrawals.
- You will be penalized if you withdraw funds before 59 ½ (except under very limited circumstances) or fail to start taking distributions by age 70 ½.
- You cannot contribute to a traditional IRA if you are older than 70 ½.
- Roth IRAs are funded with post-tax contributions so they don't provide any current tax savings.
- Qualified withdrawals made after age 59 ½ are tax-free.
- You can make earlier withdrawals, without penalties, if you become disabled or are using the money as a first-time home buyer or to pay for higher education.
- Roth IRAs do not require you to take payments by age 70 ½.
Yearly contribution limits apply to both traditional and Roth IRAs; they change annually with inflation. Check with the IRS Website to determine the maximum contribution to any IRA, and whether you qualify for any "catch-up" provisions that would allow you to increase your contributions. Ask a financial expert for all the ins-and-outs of IRA rules and regulations.
Tips for retirement success
- Plan to have contributions deducted directly from your paycheck into your retirement account. Many companies offer automatic 401(k) enrollment plans, as well as auto-escalation contributions. Money you don't see, you won't miss.
- Financial planning experts recommend that you put aside 10 percent of your income for retirement while in your 20s, and increase that amount by about 5 percent per decade thereafter.
- Maximize your giving contributions—and take advantage of any "matching funds" offered by your employer.
- Slow and steady wins the race! Small amounts invested monthly add up in the long run.
Don't throw in the towel!
Sound overwhelming? Remember that saving for retirement is a marathon, not a sprint. Regular payments into a retirement account—just like daily, long-term training and planning to run a marathon— pay off in good financial health. Just keep going, even if your pace sometimes slows to a walk!
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