If you’re planning for retirement and aren’t sure which retirement vehicle is best for you, don’t fret. A couple options can be used in tandem — specifically, IRAs and 401ks — to provide differing advantages for building up the nest egg you’ll need to last a lifetime.
401k vs IRA – they each have their pros and cons, but both are invaluable tools as pensions become a thing of the past. Not too long ago, pensions were the standard retirement option and provided guaranteed retirement income based on years of experience regardless of how the stock market performed. If the stock market soared, the pension payout would remain the same as if it completely collapsed. Employers have since dropped these plans, as they were too costly to maintain.
Modern workers planning for retirement must take a hands-on approach to saving for retirement. Here’s what you need to know about 401ks and IRAs, and how to utilize both to their maximum potential.
Employer-provided 401ks have replaced pension plans as a standard. With a 401K, you choose what percentage of your paycheck you want taken out and put into a retirement account.
What makes the 401K useful is that most employers will match a percentage of the money you invest in a mutual fund: This is essentially free money and a guaranteed return you can’t get anywhere else. For example, an employer might match 50 percent of all the money you deposit for up to six percent of your paycheck. If you choose to contribute more than six percent, that money won’t be matched.
You can contribute a maximum of 18 thousand dollars per year of your own money into a 401K account. The bonus money put in by your employers does not count towards the 18 thousand dollars.
If you want to take out your money before you turn 59 and a half years old, a costly 10 percent penalty puts a big dent on your savings. However, you can do a penalty-free hardship withdrawal to pay for medical expenses, funeral costs and a few other situations. When you do make a withdrawal — whether for emergency reasons or when you reach the required age to skip the penalty — keep in mind that the money is taxed as regular income.
When you decide to participate in your employer’s 401K plan, do a little research to see where the money is going. You don’t need to be a stock-picking expert, but check to see if there are high fees associated with whatever fund your money is going into. According to U.S. News & World Report, the average mutual fund fee is 1.25 percent. This sounds small, but over 30 years this can shrink a potentially 945-thousand-dollar retirement account to a much more modest 757 thousand dollars.
A big downside to the 401K is that many employers have a vesting period — meaning you’ll need to work at the company for a certain amount of years in order to receive the full amount of bonus matched money that they provided. This is a problem if you plan on switching jobs within a couple years, unless your company is one of the generous ones that instantly vests its employees. Consider how long you plan to stay at a company when deciding how much to contribute to your 401K.
The 401K is provided by your employers, but an IRA is a DIY investment option that requires a little more research alongside a few nice benefits.
Essentially, you’re allowed to contribute up to 5,500 dollars a year (or 6,500 dollars if you’re older than 50) into accounts that can grow with generous tax breaks. You choose the investments yourself, so you have the freedom to make the portfolio as safe or as volatile as you’d like.
There are two options for those opening up an IRA. The Roth IRA is the easiest, as it means that the money you invest can be withdrawn completely tax-free once you hit the age of 59 and a half years. Traditional IRAs are taxed upon withdrawal, but the amount you contribute can be deducted from your taxes each year. Every situation is different, but Roth IRAs are the way to go for most people.
As with 401Ks, IRAs take a 10 percent penalty on the money you withdraw before turning 59 and a half years old. However, 10 thousand dollars can be withdrawn penalty-free in order to pay for your first house, and options are available to withdraw without penalty for large medical expenses.
The tax benefits make an IRA a great way to invest for retirement. Most people also woefully underuse it — 80 percent of adults don’t have an IRA.
401K vs IRA: Which One to Pick?
At a minimum, try to contribute at least whatever percent of your paycheck is the maximum amount that can be matched. Contributing less than the maximum amount matched leaves money on the table. In addition, try to contribute the maximum 5,500 dollars to whatever IRA you have. Anything beyond that is a nice bonus.
IRAs and 401Ks aren’t best used as an “either/or” option. They’re most effective when used in tandem.