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Retirement may be decades away, but it’s crucial that you start planning for it as soon as possible. The best way to fund your golden years is to start saving and investing early. That way, you’ll be able to benefit from the power of compounding returns, allowing your portfolio to grow exponentially. You can do this with a retirement savings account: an investment vehicle with lots of benefits designed to encourage saving.
401(k) vs. IRA
401(k)s and IRAs (individual retirement accounts) are two very common retirement savings accounts with some important differences.
401(k)s are offered by employers to their employees. With a 401(k), you elect to contribute a percentage of your monthly salary to the account. The annual contribution limit for 2022 is $20,500. Your employer may then match your contributions (to a limit), effectively increasing your money before it’s even invested – something you can take advantage of. You can choose how your 401(k) is invested by picking from a limited selection of mutual and index funds.
An IRA, on the other hand, is something you set up on your own. IRAs let you save a little extra for retirement, since you can have one in addition to a 401(k), and the annual contribution limit for 2022 is $6,000 ($7,000 if you’re 50 or older). While employers don’t match IRA contributions, the accounts typically offer more investment choices and flexibility than a 401(k).
Traditional vs. Roth accounts
401(k)s and IRAs can either be traditional or Roth accounts. The key difference between the two lies in the timing of their tax advantages.
With a traditional account, you contribute pre-tax dollars. Put differently, contributions come out of your paycheck before the IRS takes its cut, which ends up reducing your tax bill today. The money in the account then grows completely tax free – that is, you pay no taxes on capital gains, interest, dividends, and so on. However, withdrawals are taxed at your income tax rate when they’re made (presumably in retirement). Because traditional accounts lower your tax bill today, they should be considered when your current tax rate is higher than your expected tax rate in retirement.
With a Roth account, you contribute after-tax dollars. Put differently, contributions come out of your paycheck after the IRS takes its cut. As with traditional accounts, the money then grows completely tax free – again, you pay no taxes on capital gains, interest, dividends, and so on. And since you’ve already paid tax on contributions, you don’t have to pay tax on withdrawals. That makes Roth accounts a considerable option when your expected tax rate in retirement is higher than your tax rate today.
It’s important to note that eligibility to contribute to a Roth IRA is based on your income. Your modified adjusted gross income (MAGI) must be under $153,000 if you’re single and under $228,000 if you’re married filing jointly to contribute for the 2023 tax year. On the other hand, anyone with earned income can contribute to a traditional IRA.
Funding your retirement
There are different ways to use your retirement savings account to provide you with regular income at retirement. You could use it to generate investment income in the form of bond coupons, stock dividends, real estate rental payments, and so on.
The best way to fund your retirement is to start saving and investing early, so you can benefit from the power of compounding returns.
401(k)s are offered by employers, who may match workers’ contributions, while IRAs are set up individually and typically offer more choice and flexibility.
Traditional accounts offer tax benefits today and are best when your current tax rate is higher than your expected tax rate in retirement, otherwise Roth accounts – which allow for tax-free withdrawals at retirement – may be a better option.