Most people have dreams of what they’d like to enjoy in retirement – drive cross country, explore new hobbies, and see the world. If you’re one of these people, planning for your retirement is crucial so you can live those dreams. As the old idiom goes, it’s never too late to start saving. So, as a final installment to my introduction to the various retirement savings plans, here is a discussion of 401(k)s. To catch up, please see these articles: The Traditional IRA and its Benefits and Retirement Savings for Young Adults.
If your employer offers a 401(k) plan, sign up immediately. A 401(k) is a tax-qualified, defined-contribution pension account. Under the plan, the employee directs retirement savings contributions directly from his or her paycheck. In addition, the employer may even match these contributions; which is like free money! The contributions are deducted from the employee’s paycheck and are limited to a maximum pre-tax annual contribution of $18,000 as of 2015 (and $24,000 for clients age 50 and over). There are 403(b) plans for nonprofit institutions and 457(b) plans for government employers.
When selecting the right plan for you, there are income tax consequences to consider. First, you can select the traditional 401(k) option where employees contribute pre-tax earnings to their retirement plan. The alternative, if offered by your employer, is the Roth 401(k). A Roth 401(k) is more attractive for folks who anticipate being in a higher tax bracket when they retire; the Roth 401(k) allows for tax free growth and distributions, provided the contributions have been invested for at least 5 years and the account owner has reached age 59½. In a traditional 401(k), while contributions are tax deductible, the distributions are all taxed as ordinary income.
The IRS has imposed severe penalties on withdrawals of retirement contributions while a person remains employed at his or her company and is under the age of 59½. Generally, there is a 10% penalty and the distribution will be taxed as ordinary income. This is just more incentive to keep that money safely stored away until you’re ready to begin your retirement dreams, when you’ll likely need the money the most. Account owners must begin making distributions from their accounts by April 1 of the calendar year after turning age 70½ or April 1 of the calendar year after retiring, whichever is later. However, there are some exceptions for early withdrawals, such as in cases of certain hardships.
So, which plan is right for you? An IRA, Roth IRA, or a 401(k) plan? At Mint.com, they share five reasons why having both an IRA and a 401(k) may be good for you. Good luck!