IRA and 401k – The Basics

You probably already know that you should be saving for your retirement. If you are not already saving for your retirement you may be unsure which retirement plan is best for you. There are numerous retirement plans to choose from but we will just look at some of the most common ones.

IRAs

There are two different types of Individual Retirement Accounts, Traditional IRAs and Roth IRAs. You can open either of these without having to go through your employer. These retirement accounts are often used to roll company retirement accounts into, so the transfer is not taxed.

Traditional IRAs allow the taxpayer to contribute up to $5,000 per IRA year or $6,000 per year if you are age 50 and above. These contributions are tax deferred until the individual withdraws the money at retirement.

Roth IRAs were started in 1998 as a result of the Taxpayer Relief Act of 1997. The main difference between a Roth IRA and a Traditional IRA is when the money is taxed. Where Traditional IRAs are taxed when the money is pulled out of the account, a Roth IRA is taxed before the money is put in the account. This allows for the taxpayer to withdraw funds at retirement without being taxed on those withdrawals.

Defined Benefit Plans

Defined Benefit plans, (DB) are employer-sponsored retirement plans that hold monthly benefits for the taxpayer at retirement and can only be contributed to by the employer. These benefits can be set at a specific dollar amount each month or can be calculated with a formula based on years of service and retirement salary. Since ERISA in 1974, many employers have moved from Defined Benefit plans to Defined Contribution plans. Traditional pensions of this type are becoming increasingly rare and comparatively few employers now offer them.

Defined Contribution Plans

Unlike Defined Benefits plans, Defined Contribution plans (DC) allow the employer, employee, or both, to contribute to the employee’s account. These investments often come in the form of mutual funds or stock in the company and as a result, your retirement account is usually directly linked to the performance of the mutual funds or how well your company stock does.

There are numerous types of Defined Contribution plans that your employer can contribute to on your behalf, including a 401(k), profit sharing, Saving Incentive Match Plan for Employees (SIMPLE), ESOP plans, and SEPs. These plans all have different stipulations on what an employer can add and how often it can be changed, but they all must be employer sponsored.

Your choice of retirement plan will be somewhat dependent on what retirement plans your employer offers. If you are self-employed you have other retirement options that will be covered in another post. No matter what route you decide to go to plan for your retirement, whether it is an individual retirement plan or an employer sponsored retirement plan, the biggest thing is that you are planning. There is a different plan or set of plans for every person in every situation, so work with your local retirement planner to figure out what will be best for you in the end.