While there are numerous options for when it comes to planning your retirement, most investors typically rely on either 401(k) plans, IRAs, or a combination of both. In this piece, we take a look at the differences between 401(k)s and IRAs, as well as other retirement planning tips.
What Is an IRA?
An Individual Retirement Account (commonly know as an IRA) is a retirement savings account for U.S. workers. IRAs are useful in retirement planning because they provide various tax advantages, and some states even have laws to protect IRA accounts from lawsuits or creditors. There are several types of IRAs available today, each of which has rigid rules regarding contribution and qualification, be sure to check out our IRA Guide to make choosing the right IRA an easier process.
What Is a 401(k)?
A 401(k) is a type of retirement savings plan that is sponsored by an employer. The plan has tax deferred benefits, allowing you to contribute to the account with pre-tax dollars. Employers often match a certain percentage of contributions. Investors have control over how their money is invested and are typically given a choice of a handful of stocks, funds, and bonds. Like IRAs, 401(k)s tend to have strict requirements concerning when money is withdrawn, so be sure to read our Simple Guide to Understanding 401(k)s.
How IRAs Can Offer More Flexibility Than 401(k)s
The Benefits of IRAs
First of all, IRAs can be opened by anyone working; you do not have to worry about whether your employer offers a 401(k) or not. Because only roughly half of employers offer 401(k)s and only about 40% of employees enroll in their respective 401(k) plans, it leaves many workers on the sidelines when it comes to these employer-sponsored retirement accounts. Thus, IRAs tend to be a more popular vehicle for saving and investing for retirement.
Pros and Cons of 401(k)s
Though some workers do not have the benefit of opening a 401(k) because their employer does not offer one, the shocking data is that only 40% of U.S. investors take advantage of their companies’ 401(k). There are many advantages that 401(k)s have for building long-term retirement wealth, like employers matching funds, but investors miss out on the upside.
Also, most people these days do not hold on to the same job for their entire career. As such, the employer-sponsored 401(k) at a job you could be leaving in the future will then be null and void; you need to rollover the account to another type of retirement account like an IRA. This leads to a greater concentration of investments into IRAs versus 401(k)s. See, also A Guide to Tax-Advantaged Savings Accounts.
There is also more flexibility when it comes to an IRA versus a 401(k). Typically, 401(k)s are managed by an employer-picked administrator; you are at the mercy of what this manager decides to invest in and the fees that these investments and funds might incur. On the other hand, IRAs allow you to pick what type of investments you want. For dividend investors seeking tax-advantage investments with compounding returns, this can be a great way to grow retirement savings. For more on how dividends and IRAs are a good retirement strategy, check out Dividend Stocks in Roth IRAs: An Exceptional Retirement Strategy.
Which Is Right for Me?
Luckily, investors do not necessarily have to choose between IRAs and 401(k)s when preparing for retirement. If you have the option to open both, the best thing to do is follow through on opening each retirement account. This allows for the flexibility of future retirement plans in the event you leave your job or face another typical life change. The most important thing is to start planning for retirement and saving as soon as possible; this way you can settle into your retirement years with a healthy nest egg to continue on with your desired lifestyle.
Be sure to check our our IRA Comparison Table for more options.
Retirement Account Withdrawal Tax Rates
Now that we’ve discussed the differences between IRAs and 401(k)s, another important topic to highlight is one of the most common question regarding these retirement accounts: What will the tax rate be when you actually begin your withdrawals at retirement age?
The answer to this question varies depending on the different retirement accounts and various stipulations and rules that cause the rates to vary. To get the most up to date information regarding your retirement account distribution tax rates and how it will affect your retirement income, consult with your financial advisor or tax professional.
Tax Rates of Withdrawn Funds
For the most part, the withdrawn funds taken from Traditional IRAs are taxed as normal income at the time you withdraw. The benefit in these accounts is that the contributions made to the IRA are either from pre-tax income or tax-deductible income. 401(k) retirement plans have their withdrawn funds taxed as normal income as well.
Below are the 2014 tax brackets for income tax according to Bankrate.
|Tax rate||Single filers||Married filing jointly or qualifying widow/widower||Married filing separately||Head of household|
|10%||Up to $9,075||Up to $18,150||Up to $9,075||Up to $12,950|
|15%||$9,076 - $36,900||$18,151 - $73,800||$9,076 - $36,900||$12,951 - $49,400|
|25%||$36,901 - $89,350||$73,801 - $148,850||$36,901 - $74,425||$49,401 - $127,550|
|28%||$89,351 - $186,350||$148,851 - $226,850||$74,426 - $113,425||$127,551 - $206,600|
|33%||$186,351 - $405,100||$226,851 - $405,100||$113,426 - $202,550||$206,601- $405,100|
|35%||$405,101 - $406,750||$405,101 - $457,600||$202,551 - $228,800||$405,101 - $432,200|
|39.6%||$406,751 or more||$457,601 or more||$228,801 or more||$432,201 or more|
In a Roth IRA the withdrawn distributions are 100% tax free as long as your are between the ages of 59.5 and 70.5. The difference with a Roth IRA is that the contributions are made after-tax. If you expect to have a high income tax rate during your retirement, then a Roth IRA is probably the best option to avoid paying the taxman a substantial portion of your income in retirement.
The good thing about these retirement accounts is that holdings are tax deferred – meaning the capital gains and dividends earned from investments in the accounts are not taxed until you ultimately withdraw the money in retirement. At that point these funds are taxed as normal income if in a Traditional IRA or 401(k) as stated above, which can be a rate from 10% to 39.6% depending on your income.
After you retire, your income, and thus your income tax rate, is likely to be lower than it was when you were working. This factor should be taken into consideration when determining what retirement account plan is best for you. While retirement plans that allow for tax-deductible contributions seem appealing in the short-term, long term factors in retirement can result in saving more from potential taxes if you opt for a retirement plan with tax-free distributions. Keep in mind that everyone has a unique situation, so shaping your plan for how it suits you best is necessary.
Nest Egg Withdrawal Rule of Thumb
Figuring out a budget for everyday living expenses in your golden years can be a tough task. Now that you have some idea of how taxes may affect your retirement account withdrawals you may be wondering how much you should actually need during retirement.
Traditionally, the general rule was that you should withdraw 4% of your overall nest egg from your retirement accounts each year, and your money should last as long as you do. However, this is assuming that your assets continue to grow at that same rate (or preferably more) to support your future income stream. As is the case when it comes to investments, this rate of return can fluctuate year to year, especially in volatile markets and a struggling economy [see also The Pros and Cons of Compound Interest].
As such, you need to check up on your finances every year to stay up to date on your current situation. Consulting with a financial planner may help determine how much exactly you need and should withdraw each year.
Before considering withdrawing funds, make sure that you have gone thoroughly over your retirement financial plan. Below, we highlight some key tips for saving for your retirement and how to reduce costs.
Saving Tips for Your Retirement
It’s never too early to start saving for your retirement … and it’s never too late. Whether you are ahead of the curve when it comes to your retirement savings goals or perhaps behind the ideal course, there are ways to make sure you have a source of income into your golden years.
How Much Should You Start Saving?
Depending on your individual financial needs, the amount of money you should save for retirement can vary. A good rule is to try and save 10% of your overall salary, but the more you can afford to save the better off your retirement position will be. This is especially true as the reliance on Social Security and company pension plans dwindles. Aiming for a savings goal of 15% or more of your salary is probably the best way to ensure a comfortable nest egg. You should also consider building an emergency fund.
Studies have found that for an individual to maintain their standard of living in retirement they will have to save about 11 times their annual earnings. This may seem like a daunting task, but by starting early and saving 10% to 15% of your salary, it can allow you to to retire in an ideal financial position. Keep in mind, the later you wait to start saving, that percentage will rise; with less financial flexibility as you age it can make it much more difficult to reach that desired nest egg.
Take Advantage of Different Retirement Options
There are a variety ways to start saving for retirement that go beyond IRAs and 401(k)s. Certificates of Deposit and Money Market Accounts are two other popular options. Learn more about different tax-advantages savings accounts in our Retirement, Education & Health Savings Accounts Guide.
Reducing Your Retirement Costs
When coming up with a retirement plan, many Americans consider how much retirement income they’ll need in order to enjoy their current quality of life. What most don’t consider is how to stretch those retirement dollars by cutting out extraneous and unnecessary expenses. Below we highlight some cost reducing ideas.
Cutting Your Real Estate Costs
Downsizing to a smaller home is an option, but you have to consider what has happened to your real estate investment. If you are still carrying a mortgage, you will need to decide if the home you are currently living in makes sense for the size of your family (assuming most near-retirees are empty-nesters — no more kids living with them). It may make sense to look at areas that are more tax-friendly if a move is possible.
If you’re staying within the same area, then it’s possible that other houses will be affected by real estate price cuts in the same way that yours has been. If this is the case, then it makes sense to move to a small home. Not only will you be able to bank some cash from the profit of selling your house and moving into a less expensive one, but you’ll also be dealing with less in the way of heating, electricity, property taxes and maintenance costs. Less house means lower bills and less that can go wrong.
Learn more about these issues in our How to Invest in Real Estate: A Crash Course.
Eliminate Unneeded Insurance
As you get older, there are many types of insurance that simply don’t apply to you any more. Disability insurance, for instance, starts to make less and less sense. Once you stop working, there’s really no need for it whatsoever.
You may also want to look into cashing in a life insurance policy. Though you don’t need to have a specific reason in mind when withdrawing funds, most policy owners set up permanent life insurance knowing that they had it as a way to save money. Remember, you must always keep your term life insurance policy in tact.
Other Expenses to Cut for Retirement
Everyone should understand that high-interest credit cards with any outstanding balances should be eliminated as soon as possible. The way you shop needs to be more in line with how you expect to live comfortably. Getting rid of credit card debt and automobile loans are two things to address first.
The Bottom Line
The hope is that one has built up a nice retirement nest egg so that one’s quality of life can be maintained in the later years. Remember to keep funding all of your retirement-focused accounts in the years up to you possibly deciding to retire. You need to keep your money working for you when it comes to 401(k)s, IRAs (perfect for high-quality dividend-paying stocks), and other pensions.