Are You Ready for Retirement?: Essential Information on IRAs and 401(k)s

While you’re young, you may not be thinking about saving for retirement. You’re probably more focused on paying off student loan debt, searching for a job, or buying a house. But, starting to save for your financial future early will only benefit you in the long run. Start your retirement planning as early as you can.

downtown street sign pointing to retirement

Think about it like this, the sooner you start saving for retirement, the more money you’ll gain down the road (Can you say compounding interest!?). If you are able to put $4,000/year into a Roth IRA for 40 years and earn 8% annually, you could be a tax-free millionaire by the time you retire. There are two main ways to save for retirement: an employer-sponsored 401(k) or a self-sponsored IRA.

What is a 401(k)?

A 401(K) is an employer sponsored retirement savings plan. It allows employees (YOU!) to save and invest a portion of their paycheck before it is taxed. In fact, taxes will not have to be paid on this portion of your income until the money is withdrawn from the account, most likely upon retirement. With a 401(k), you control how your own money is invested.

You should invest in your 401(k) as much as possible, while still having enough money to cover your monthly expenses, build your emergency savings, and pay down any debt you have. At the very least, invest enough to get the full company match that your employer may offer. You don’t want to leave free cash on the table. Many 401(k) plans offer matching funds. This can be a dollar-for-dollar match, 50-cents-on-the-dollar match, or a percentage match.

How a Company Match Benefits You

How does a company match work? Let’s use the popular 3% company match as an example. If you contribute 3% of your $50,000 salary ($1,500), your company will put another $1,500 into your 401(k). Of course, you can add more than $1,500, but your company won’t match beyond 3%. The rules for matching funds vary, so be sure to check with your employer about qualifying for matching contributions. Simply put, invest enough money so that you are able to get the max amount of free money from your employer.

In most cases, you can’t tap into your employer’s contributions immediately. Your ability to collect your company match depends on vesting. Vesting is the amount of time you must work for your company before gaining access to its payments to your 401(k) (your payments, on the other hand, are often available immediately). Having an employee wait to have access to this match is an insurance against employees leaving early.

On top of that, there are complex rules about when you can withdraw your money and costly penalties for pulling funds out before retirement age. For example, your company may require you to work with them for two years before you’re fully vested. Meaning, if you quit before the two-year mark, you won’t be able to keep 100% of the contributions from your employer.

Types of 401(k)s

Traditional 401(k)

  • A traditional 401(k) is the most common and, chances are, this is what your company offers to their employees.
  • Wages are contributed before taxes from each paycheck.
  • Taxable income drops by the amount you contribute.
  • You pay income taxes on contributions and earnings upon withdrawal.
  • You cannot access funds before age 59 ½
  • If you withdraw early, expect a 10% penalty on top of usual taxes.

Roth 401(k)

  • Contributions are made with money that has already been taxed.
  • No taxes are paid upon withdrawal.
  • You can access your money as long as you have held the account for a minimum of 5 years, allowing more flexibility.

What is an IRA?

Individual Retirement Accounts (IRAs) are savings plans created by the federal government, primarily used for retirement planning. Unlike the 401(k), which is provided by your company, you open an IRA on your own. But very similar to a 401(k), an IRA allows you to contribute a portion of your pay into an investment account with tax benefits. Any individual that earns an income, or receives alimony, is eligible to open an IRA. Income from other sources does not qualify.

Types of IRAs

Traditional IRA

A Traditional IRA allows tax-deductible contributions. The amount you contribute is solely up to you, and your contributions do not need to be consecutive; they can be made as your personal financial budget allows. You have the ability to contribute $5,500 ($6,500 if you are 50 or older) a year.

Once you reach age 59 and a half, you may withdraw from the IRA. You will be taxed as soon as the first withdrawal is made. For Traditional IRAs, you must begin making withdrawals by April 1st of the year that you turn the age of 70 and a half.

If you should need to pull distributions from your Traditional IRA prior to the age of 59 and a half, you may suffer a 10% penalty. However, there are a few circumstances that negate the penalty, such as:

  • In the event of death or total disability
  • Withdrawing nondeductible contributions (these earnings will be taxable)
  • As a qualified first-time homebuyer, up to $10,000 in your lifetime.
  • This distribution must be used within 120 days to pay costs. This particular circumstance applies to expenses of you, your spouse, child, grandchildren, or ancestor of such individual.
  • If the withdrawal is used to pay qualified higher-education expenses
  • If you use the withdrawal to pay for medical expenses in excess of 7.5% of your adjusted gross income or to purchase health insurance after 12 weeks+ of receiving unemployment compensation
  • If the funds are paid out in a series of payments made over your life expectancy, or a combination of you and your beneficiary

If you are an active participant in an employer-sponsored retirement plan, your IRA contribution deduction will be based on your adjusted gross income. Those below a set “threshold” may make deductible IRA contributions, and those above that level are not entitled to any IRA deduction.

Roth IRA

A Roth IRA is one of the best retirement savings plans for young people. Unlike Traditional IRAs, Roth IRAs do not have an age-requirement for withdrawals, and any individual with earned income, up to $95,000/year for single filers and $150,000/year for joint filers, are eligible.

Yearly contributions, up to $5,500 ($6,500 if you are 50 or older) to this federal program are nondeductible, and withdrawals are tax-free as long as the plan has been open for a minimum of five years and the account holder is at least 59 and a half.

If the standards above are not met, withdrawals are subjected to a 10% penalty. However, there are a few circumstances where the penalty is waived, including:

  • If the individual is 59 and a half, deceased, or permanently disabled
  • If the individual is taking equal payouts over his/her life expectancy for at least five years or until age 59 and a half
  • If the funds being taken out are being used for any of the following:
  • College expenses
  • First-time home purchase, up to $10,000
  • Non-reimbursed medical expenses

Do you participate in an employer-sponsored retirement plan? No worries! You can still make non-deductible contributions to a Roth IRA savings plan.

Essential Information on IRAs

Why Should I Transfer to an IRA from a 401(k)?

If you’re close to retirement age or are planning to leave your current job, you’re probably wondering what to do with your 401(k). Should you leave it at your current workplace? Or should you cash it out? Neither are great options. For example, simply cashing out your 401(k) is not ideal, as you will most likely lose money due to taxes.

What you need is a third option: Transfer your 401(k) to an Individual Retirement Account (IRA). If you transfer to an IRA, you will be saving yourself not only time but money and frustration too. If you still need convincing, just take a look at these three reasons why transferring to an IRA from your 401(k) is an excellent option for you.

1. Save some dough on taxes

If you choose to transfer to an IRA, you can select what kind of IRA is best for you: Traditional IRA or Roth IRA. Both options will help you save on taxes in different ways, and which type you choose depends on your financial situation. A Traditional IRA allows you to make contributions that, depending on your income, may be tax-deductible. Your earnings in a Traditional IRA can grow, tax-deferred, and after age 59.5, withdrawals are taxed as current income but are penalty-free.

On the other hand, contributions to a Roth IRA are not tax-deductible. Your earnings in a Roth IRA can grow tax-free, and after age 59.5, or after the account is five years old, you can begin to make withdrawals that are tax- and penalty-free. Check first to see if you are eligible for Roth IRA; if your income is above a certain level you won’t be eligible.

2. Open doors to investment

Usually, your 401(k) has few funds available, and therefore diversification is limited. However, if you transfer to an IRA, you’ll have a wide array of investment choices available. From stocks to bonds to mutual funds, you’ll have many more options in which to invest your money.

3. Manage your account with ease

By transferring to an IRA, you’ll have an easier time managing your account. If you transfer to an IRA and your spouse has an IRA as well, you can combine the holdings and have them all in one place. You’ll be able to look at all your holdings and keep track of your investments with ease.

Do you have more questions about retirement planning with a 401(k) or IRA?  Tell us what you want to know in the comments below!

Kara Vincent
Kara Vincent

Kara Vincent is the Financial Officer at Lancaster Red Rose Credit Union.