Sure, the thought of retirement may seem downright laughable early in a career while squaring away student loans, outfitting your new digs and leaving some cash for weekend adventures. But the powerful impact of time on your investments is no joke.
Saving something each month starting now – even just $50 to start – can instill a lifetime habit with potential to secure the lifestyle you want once your working years are behind you. Two of the most popular vehicles for retirement savings are a 401(k) and an individual retirement account (IRA), and each has benefits.
What’s the difference?
A 401(k) is an employer-sponsored plan, so you can only participate if your workplace offers this benefit and you meet eligibility requirements (some employers may have a minimum age or minimum service requirement to take part). An IRA, however, is self-directed, so you can open and contribute to an account so long as you have earned income. Both accounts offer tax advantages.
With a 401(k), your contributions are made with pre-tax dollars. As a result, your taxable income is reduced, lowering your current tax bill, and you don’t pay taxes on the funds until they are withdrawn, ideally in retirement (more on that later).
A Traditional IRA operates much like a 401(k). Contributions may be tax deductible, reducing your current tax bill, and funds are taxed upon withdrawal. Another option is a Roth IRA, which allows you to contribute after-tax dollars and make withdrawals tax-free, meaning you pay taxes now and avoid taxes on the appreciation of your assets.
Why choose a 401(k)?
Beyond the tax advantage, a 401(k) offers numerous benefits:
It’s easy. Once you elect to participate, contributions are deducted automatically from your paycheck, reducing the temptation to spend before saving.
Higher contribution limits for all. All eligible employees can participate in a 401(k) regardless of their income, and annual contributions can be significant. For 2018, those under 50 can set aside up to $18,500, while those 50 and over can save up to $24,500. With IRAs, contribution limits phase out with higher incomes, which may not be a concern early in a career, but it could come into play as your experience and salary grow. For 2018, contributions are limited to $5,500, or $6,500 for those 50 and older.
Free money with matching. To encourage participation, many employers include a money match formula. For instance, an employer may contribute 50 percent of up to six percent of your elected contribution – in other words, up to three percent of your pay.
Try to contribute enough to take advantage of a match, but be aware of vesting schedules. You may need to complete a certain number of years of service to keep 100 percent of your employer’s contributions (your contributions are always fully yours).
Possible borrowing. Some employers may allow plan participants to borrow from their 401(k) in certain circumstances. Here’s where you can access money early while avoiding penalties, but it’s important to pay close attention to the details.
You can borrow from your retirement, but you need to repay the amount, plus interest. And, repayment needs to happen while you are still an employee. Otherwise, your loan could be considered a distribution, which means you’ll owe taxes and, if you’re under the minimum distribution age, penalties.
Why choose an IRA?
If a 401(k) isn’t an option, then an IRA is a no brainer. Even if you participate in a 401(k), you might add an IRA to build your nest egg faster and potentially reduce your tax bill further.
More investment options. As an IRA is self-directed, you can open an account with any financial institution and choose from a multitude of investment options – stocks, bonds, mutual funds, exchanged traded funds.
An employer’s plan typically has a set number of investment options from which to choose, so if the associated expenses are high, you can’t shop around for similar options with lower fees.
More flexibility for cashing out. While both 401(k)s and IRAs discourage early withdrawals, IRAs do offer some exceptions to assessing early withdrawal penalties. For instance, the funds may be used for eligible higher education expenses or even toward the purchase of a first home.
It can still be easy. Even though you’ll need to do the legwork of selecting investment options and opening an account, many institutions offer automatic investment plans so that you won’t need to think about when or how much to contribute each month.
Whether you choose one option or both, taking time to understand the benefits and beginning contributions now can make for a financially awesome retirement.