401k Vs IRS - Do Something
Retirement savings is crucial for everyone’s future and often people simply don’t understand what retirement accounts are and how to go about using them much less using them to their advantage. Therefore we are discussing what they are, what’s the difference and why you need one or both.
Let’s start with understanding retirement savings.
Retirement might seem like a distant very far off thing that you can worry about later, especially if you're in your twenties or even your thirties, but the reality is that the sooner you start saving, the better off you’ll be. And on the other side of that, the later you wait the harder it is to catch up. Time has a way of passing quickly and getting away from us as life gets busy. Before you know it, it’s time.
So why is it so important? Because, Retirement savings ensures that you have enough money to live comfortably when you are no longer working. And, we have to be honest, in that social security is not a guarantee. In fact, the younger you are, the less likely there will be funding in the social security program for you to use, at least not 100%. And even there is, will it be enough? It’s very likely a social security check will not equal your current paycheck or what you would be earning at retirement age. Your income is most likely going to increase as you get older and so will your expenses.
In May 2024 an average retirement check was $1778. This number will adjust as the government adjusts it for cost of living and it will also vary depending on what age you retire. And to clarify, this is a monthly check totally approximately $21,336 a year which would be very difficult to live on. Especially when you factor in the record inflation we have been experiencing. In short, relying solely on social security just isn’t a safe bet. This makes having a personal retirement savings plan crucial.
What is a 401k?
A 401(k) is a retirement savings plan offered (or sponsored) by an employer. It allows employees a way to save and invest a portion of their paycheck before taxes are taken out. The money is taxed are when withdrawals are made from the account, most likely at retirement age.
There are a few things that make 401(k)s attractive:
Employer Match: Many employers offer to match a portion of your contributions. This is essentially free money and can significantly boost your retirement savings.
For example, if your salary is $50,000 a year and you choose to contribute 6% of your salary each year that equals a $3000 contribution for the year.
If your employer offers a match of 50% of employee contributions up to 6%, this would mean that they would contribute half the amount you do. So, in this instance, they would then contribute 3% or $1500.
One thing to consider with your 401k. Many employers who offer a match will also have what’s called a vesting schedule. Vesting is simply talking about ownership of the money in the account. The money you put in is yours to keep. It’s your money that you put in! The employer money is where vesting is important.
You often have to work for a company for a certain amount of time to be what’s called 100% vested. For example, if that time is 6 years and you stay for the 6 years, then you choose to leave that job, you will be entitled to your contribution as well as the matched funds.
If you leave before that time, then the matched funds won’t be available to you.
Some employers have a schedule, where you can still get a certain percentage as you work up to the 100% timeframe. So, if you left before the fill vesting time, you would be entitled to a portion of the employer match.
Bottom line, matching and vesting can really vary depending on the employer. It’s best to ask what is available at your company.
One other important matter to consider when deciding how much you will contribute to the 401k is that the IRS actually limits how much you can put in each year and that includes the employer match. For 2024, the limit is $22,500 or $30,000 if you are over 50.
There are tax advantages for a 401k as your Contributions are made pre-tax, which means you reduce your taxable income in the year you contribute. Then that investment grows tax-deferred until you withdraw the money in retirement.
Your money will be invested on your behalf. We recommend contacting your HR department to determine how your investments are distributed.
For example, if you are younger and further from retirement age, you can be more aggressive and perhaps invest in places that are little more risky which can result in a higher return. If you are younger, you have time to do that and risk perhaps losing some money, but you will still have time to make it back before you would need it.
On the other hand, if you are closer to retirement age, you may want to move your investments to less risky ventures. This way you can still see growth but not risk losing money that you won’t have time to make back before you retire.
You can withdraw from a 401k early but there are penalties, usually 10% and then you would have to pay the income tax on that amount. That will change once you are 55 and if you leave your job.
At 72, the IRS will begin to require you to withdraw from the account, so that’s something to make part of your financial plan for those years.
Sometimes you can withdraw if you qualify for a hardship withdrawal. So it is possible but you will need to do the necessary paperwork and make sure your situation qualifies.
If you ever leave your job, rolling your 401k into a 401k with your new employer, or even an IRA, which we about to cover.
Let’s move to IRAs
IRA stands for Individual Retirement Accounts. Unlike 401(k)s, IRAs are not tied to your employer, which gives you more flexibility in terms of investment choices.
There are two main types of IRAs: Traditional IRAs and Roth IRAs.
Let’s start with A Traditional IRA:
With a traditional IRA you can contribute to it from your paycheck like a 401k, so you may hear it described as a deductible account.
It has that same tax advantage as the 401k as it is tax-deferred until retirement. You can’t have more than one deductible account so if you are already contributing to a 401k and want to open an IRA, it will need to be a different kind.
There are contribution limits for a traditional IRA. For 2024, you can contribute up to $6,500 annually, or $7,500 if you’re over 50.
You can withdraw from it but it will be taxed just like ordinary income and there are penalties which is usually 10% for withdrawals before age 59 ½. There may be some exceptions, so, you will need to check into those terms if you want to withdraw.
Then there is a Roth IRA
This is a great option if you have changed employers and need to roll your previous 401k and are unable to move it to your new employer as it’s not a deductible account.
The tax advantage is the contributions are made with after-tax dollars, so you’ve already paid taxes on that money and the withdrawals in retirement from that account would be tax-free.
There are income limits when contributing to a Roth IRA. Take note of the reference chart here (shared from Fidelity.com).
The Roth IRA offers a bit more flexibility because contributions, not earnings, can often be withdrawn without penalties or taxes. There are a few exceptions and variables just like with the other accounts but it’s bit easier.
Another really great thing about IRAs is they are perfect for those that are perhaps self-employed or work freelance and therefore don’t have an employer 401k program to participate in. Retirement planning is still crucial! And IRAs are a great option for their planning.
Let’s take a few minutes and compare the 401k and IRA.
1. Control Over Investments: IRAs offer more control and a wider range of investment options compared to 401(k)s. Often for a 401k those options will be limited by the employer but with an IRA, you can make those decisions a bit more freely or go to a financial advisor who can assist you.
2. Contribution Limits: 401(k)s have higher contribution limits, making them better suited for people who want to be more aggressive with their saving.
3. Taxes: Both Traditional IRAs and 401(k)s offer tax-deferred growth, while Roth IRAs are going to provide tax-free withdrawals. The best choice will depend on things like your current tax situation and your expected tax rate in retirement. Again, a financial advisor can be really beneficial here.
4. Employer Match: 401(k)s often come with employer matching contributions, which as we showed can significantly enhance or grow your savings. But IRAs don’t have this feature.
5. Flexibility: IRAs, especially Roth IRAs, offer more flexibility regarding withdrawals. So, if you anticipate that you will need to access to your funds before retirement, a Roth IRA might be a better option to consider.
One thing worth mentioning is you don’t necessarily have to choose between a 401(k) and an IRA—you can have both. And if you have that ability, diversifying your retirement accounts in this way can be a smart strategy. For instance, you can contribute to a 401(k) up to the employer match to take advantage of the free money, and then perhaps contribute to a Roth IRA for the tax-free growth.
So, both the 401(k) and IRA are excellent tools for retirement savings, and each has its own advantages. We recommend, evaluating your financial situation, consider the tax implications, and make the most of employer contributions if those are available to you.
The big thing to remember, is to start early if you can! Compound those earnings. The earlier you start, the more time you have to grow and earn. Even if you are starting out on this journey later in your life, still do it. Any money you can save for retirement will help.
Many people delay saving for retirement for a multitude of reasons. It may be financial pressures, lack of knowledge, or there is a misconception that they can’t afford it. But even small contributions can make a big difference over time. Automating your savings, taking advantage of employer matches, and seeking advice from a financial advisor can help you stay on track.
Remember, planning for retirement isn’t just about securing your financial future—it’s about ensuring peace of mind and the freedom to enjoy your later years without financial stress.
Bonus tip!
Catch up contributions! Let’s say you have started saving a bit later and you want to maximize your contributions as you are reaching retirement age. For those who are 50 years old or older, both 401(k) and IRA plans offer a "catch-up contribution" feature. This provision allows you to contribute extra money to your retirement accounts above the standard annual limits.
So How Does It Work?
· For 401(k) Plans: In 2024, the standard contribution limit for a 401(k) is $22,500. However, if you're 50 or older, you can contribute an additional $7,500, bringing your total annual limit to $30,000. That can make a big difference as that money is invested and grows.
· Now For IRAs: For both Traditional and Roth IRAs, the standard contribution limit is $6,500 in 2024. If you’re 50 or older, you can contribute an extra $1,000, for a total of $7,500.
So Why Are Catch-Up Contributions Important?
1. For Boosting Savings: They provide an excellent opportunity to significantly increase your retirement savings, especially if you feel you've fallen behind. The higher the amount being invested, the higher the potential return which equals more growth.
2. Tax Advantages: For Traditional IRAs and 401(k)s, these additional contributions can further reduce your taxable income, which will provide immediate tax benefits.
3. Compounding Growth: Like we’ve said, the more you contribute, the more potential your investments have to grow over time, thanks to the power of compounding interest.
Here’s an Example Scenario
Suppose you're 52 years old and have just started to focus seriously on your retirement savings. Here's how catch-up contributions can help:
In 401(k) Contributions: You can use the catch up concept to contribute $30,000 annually instead of $22,500. If you do this consistently over 10 years, you’ll have contributed an additional $75,000 compared to someone under 50.
For IRA Contributions: By contributing $7,500 annually instead of $6,500, you can add an extra $10,000 to your retirement savings over a decade.
These extra contributions can make a substantial difference in your retirement nest egg, which will do what? Provide more financial security and flexibility.
So again, it’s never too late to start saving for retirement, and taking advantage of catch-up contributions is a truly powerful strategy for those in their 50s and beyond. Whether you’re contributing to a 401(k) or an IRA, maximizing your contributions can truly make a big difference in reaching your goals.
As always, if you have any questions please reach out and we highly recommend that you consider consulting with a financial advisor for help creating tailored retirement plan that takes full advantage of all available opportunities so that you can succeed in ensuring a more comfortable and secure retirement.