Do the different retirement terms overwhelm you? Our friends at LearnVest explain the difference between an IRA and a 401(k) in simple terms.What’s on your mind today?
We ask because we’re thinking of something specific: retirement.
No, no, don’t go! Retirement, once you think about it, is pretty awesome.
Once you’re retired, you don’t have to get up with an alarm, brave the commuter traffic, or drink office coffee. Heck, you don’t even have to wear pants.
But the trick to a refreshingly pants-less retirement is getting started early — ideally, in your 20s. But if your 20s have come and gone, it’s not too late. You just need to get started saving as soon as possible, and to save, you’ll need to know your account options.
We can help you with that.
Let’s refresh our memories about the main types of retirement accounts available to us. There are three: the 401(k), the traditional IRA, and the Roth IRA.
A 401(k) is a free retirement account you can only get through an employer, and it holds money taken directly from your paycheck. Sometimes, said employer also contributes money your retirement fund — that’s called “matching.” Traditional 401(k) plans grow tax-deferred, meaning that you’ll pay taxes when you take the money out, not when you put the money in.
Read on for more.
A traditional IRA is set up so that your contribution each year is tax-deductible (if you’re under a certain income limit*), and you aren’t taxed on the income you make as it grows. You pay those taxes when you withdraw the money for retirement, which you’re required to begin doing at age 70½. Anyone can open a traditional IRA.
The Roth is different from the traditional in that you pay taxes upfront at today’s tax rates. In return, you never have to pay taxes on your investment earnings! This is huge. Consider the following example:
If you’re contributing $150 per month to retirement, your account will hold about $78,000 after 20 years.** Over half of that (about $42,000) is investment earnings — the money your contributions have generated just by being in the account. With a Roth, you won’t need to pay taxes when you take out any of that $78,000. With a traditional, you’re taxed on the entire sum: over $78,000.
Now you know. So start saving!
*While the 401(k) and nondeductible IRA don’t have income limits, the Roth and traditional do. You can contribute to a Roth IRA as long as your income is less than $110,00 if you are single or $173,000 if you are married. For a traditional IRA, you can only deduct if you aren’t covered by a 401(k) at work and your income is below $58,000 single or $92,000 if you are married.
**These numbers have been calculated using seven percent interest.
Source: Flickr User Mykl Roventine