When you open a 401(k) retirement plan, your employer is allowing you to contribute a portion of your paycheck towards your retirement account.
There are many benefits to 401(k) plans, such as the ease of transferring funds into your account. You may also receive tax benefits and employer-matching contributions. While you may be aware of the many benefits to 401(k) accounts, you should also be mindful of the downsides before you open an account.
One significant criticism of a 401(k) retirement plan is that there are regulations on the amount of money that employees and employers can contribute to their account each month. Also, depending on the account, 401(k) accounts may require more management than other retirement plans. Since a 401(k) account is not the right retirement plan for everyone, it is good to know if you should open an alternative retirement account, or if you should have a 401(k) in addition to another retirement plan.
An appealing alternative retirement plan is an individual retirement account (IRA). Similar to a 401(k), an IRA is an investment tool that you can earn and save money for your retirement years. In the United States, there are two IRA accounts: A traditional IRA and a Roth IRA. While they are different, both options provide certain tax advantages. They both operate on the same principle and share many similarities, such as having the same contribution limits and withdraw regulations. They both also offer options for the funds that are deposited into your account to be invested in several different investments, such as stocks, mutual funds, bonds, and certificate of deposits (CDs). An IRA is typical upon self-employed workers and small business owners. However, anyone can open and benefit from this retirement account. Now, let’s take a closer look at each IRA account.
The main difference between a traditional IRA and a Roth IRA is the way the money in these accounts are taxed. With a traditional IRA, it is common for the funds that you contribute to be tax-deductible or considered pre-taxed. Meaning, that if you contribute a specific amount of money into your IRA account that you can claim that amount as a tax-deduction on your income-tax return. As a result, the Internal Revenue Service (IRS) will not apply income tax to those earnings. It is essential that you know that tax-deductible contributions are only available to specific IRA account owners depending on their income, other retirement accounts, and tax filing status. Also, contribution limits apply to traditional IRAs. For 2018, the annual individual contribution limit is $5,500 for most cases. If you are 50 or older, you can contribute up to $6,500 each year.
If the IRS grants you a tax deduction, you are going to need still to pay taxes on the money in your IRA account. However, the taxes will only be applied once you withdraw money from the account when you are ready to retire. If you feel that you will be in a lower tax bracket when you retire, a traditional IRA may be the best option for you since it will allow you to pay less in taxes than if you were to have paid them before you retired.
While a Roth IRA is similar to a traditional IRA, it is different when it comes to taxes. If you contribute to a Roth IRA, the contributions that you make are not tax-deductible, although certain withdraws from the Roth IRA that are eligible are tax-free. Meaning, that when you contribute to your Roth IRA that the funds you provide are taxed and after the account accumulates, and you decide to retire, you can withdraw your money from the account without suffering any income taxes.
Before you choose an IRA plan, you will need to determine your current and future tax situation so that you open an IRA that is best for your finances. It is common for retirees to fall into a lower tax bracket because they are no longer making the level of income that they were making before they reached retirement age. If you believe that you will be in a lower tax bracket when you retire, then it may be best for you to choose a traditional IRA plan, since the account has its funds taxed once they are withdrawn during your retirement years.
However, it is crucial that you know that there are also many benefits to a Roth IRA plan. If you would like to pay the taxes when you deposit the money into your retirement account each month, this plan may be ideal for you. With a Roth IRA, you will not face taxation until you withdraw the money from your account when you retire. No matter which IRA account that you choose to use, you need to take the time to consider the different options carefully and how they can benefit you before you select an IRA plan. If you would like a second opinion, you can meet with an investor or financial planner to help you decide the best plan for you and your financial situation.
When seeking an alternative savings plan to a 401(k) plan, it is good to know that your other options are not only a traditional or Roth IRA. If you would like to have more control over your retirement account with no contribution limits and limited regulations, it may be wise for you to open a regular investment account. With an investment account, you have the benefit to contribute to the number of funds that you want, and when you want. For complete control, you can opt to manage the account, which includes where you invest your money or seek professional help from a broker.
No matter who manages the account, it is your responsibility, and it may require more management than a 401(k) account or an IRA. You will also miss out on tax incentives that are included with a 401(k) or IRA, which may result in you paying for the capital gains on your income growth. Therefore, with the different types of investment accounts offered in the country, you must weigh the pros and cons of each before you decide on a plan that is right for you.