Retirement… it may be a long way off but the sooner we think about it, the better off we will be when we get to our final clock out.
But saving for retirement is not a fun thing to do for most of us – many of us would rather have the cash now and worry about tomorrow, well… tomorrow. Especially as it is a confusing arena to play in, full of numbers, codes, acronyms and tax implications.
One of the simplest areas to start saving seriously for your future is by using a 401(k) and an IRA. But what are they and what is the difference?
Simply put, a 401(k) is what most employers offer full time staff as a way to put money away for the future. Traditionally many firms offered pensions offering guaranteed payments for life based on some formula linked to your wages but alas traditional pensions are vanishing as part of companies’ benefits packages. So today it is a 401(k) – or if you work in a non-profit and a handful of other types of organization a 403(b) – which is basically a type of savings account with a few extras attached.
First up the money you put into it is deducted directly from your pay packet before you pay tax on it – but you will not escape Uncle Sam’s share, you will just pay it later when you take the cash as retirement income. Why would you want that? Typically most people retire on a lower overall income which often means a lower tax bracket – so less to Uncle Sam overall.
Next, most employers will offer some form of match to your money. This is entirely up to how generous your firm is, but generally companies will match you to a certain percentage of your income you put away – maybe three or six percent for example.The golden rule here is simple – take the free money. If you do not take it, you lose it – and since you need to be saving something somehow, always take the free money. Many schemes will encourage you to put more of your income in to them – but that is your choice and there may be better alternatives out there for your additional savings.
When you finally get to retirement you claim your pot of cash and you use that to fund your golden years. How you do that – maybe just spend a small amount each year or maybe buy an annuity for example – is a topic for another day.
But what if you need your money earlier than retirement? Well you can cash it out – but since we are encouraged to save for later there is a punishment. If you take any money before 59-and-a-half, Uncle Sam will tax you at 20 percent and a 10 percent penalty.
An IRA, by contrast, is an Individual Retirement Account – you own it, not the company. It is not actually a specific product but rather a tax code which can be applied to many different financial products in the market today.
It allows you to save up to $6,000 per year before tax in a Traditional IRA – or $7,000 if you are over 50 – so like a 401(k) you pay the tax later when you take the money. Again, there are penalties for cashing out early – and high earners are not allowed to use them. It gets more complicated with another type of IRA called a Roth IRA – where you choose to pay the tax now and take the money tax free later, which can help reduce your overall tax liabilities in retirement. They can be used together as well – which is where taking sound financial advice is so important to get the best options for you.
But what actually happens with your money? In both cases there are usually a wide range of options – depending on how risk averse or aggressive you are with your money. Many 401(k) providers will offer you a range of funds you can choose to put your money in, made of of different mixes of stocks and bonds, and you select the one that makes most sense for you, which will also be affected by how close to retirement you are.
IRAs have even more options, from highly safe versions with as little risk as possible, to highly aggressive investments that can grow your money much faster but come with higher risk that you could lose too.
How do you know what is best for you and what to pick? Speak with a trusted financial professional to help guide you in making your choices, and keep them under regular review.
But one golden rule stays the same – whatever methods you choose, the sooner you start saving the better your retirement will be.