IRA, 401k, 403b: Which Retirement Plan is Right for Me?
As people start to delve into the world of investment, they may be inundated by the alphabet soup that is retirement plan acronyms. It can be difficult to distinguish between an IRA, 401k, and 403b. Plus, a lot of the information changes yearly. This guide distinguishes the common types of retirement plans, and shows how to decide which one is most appropriate for individual needs when you’re planning a budget for your daily life or saving for retirement on a budget.
Benefits of Paying Into a Retirement Fund
When parents teach about putting savings in a piggy bank, they may forget to explain the tasty bacon that is compound interest—especially when you remember that savings can lose value. Putting money in a retirement fund that is well-managed is one of the best ways to save for retirement, because it puts money to work. An investor puts money into the plan, and the money is invested into a variety of funds. Each year that the money stays in the fund, it collects interest. Compound interest means that it can collect interest on previous interest.
People can start to build retirement funds with an Independent Retirement Account (IRA), whether or not their employers offer some kind of retirement plan. Before opening an account, it is important to decide between a traditional IRA or a Roth IRA account. The contributions to a traditional IRA offer a tax deduction for the year in which the contribution is made, for those who make less than $70,000/year filing single. This is convenient in that it allows investors to effectively defer the tax for that money until they start taking disbursements after they retire. With a Roth IRA, people cannot claim the contribution on their taxes, but the withdrawals that you take may not be subject to taxation.
The maximum that people under age 50 can put into any IRA (or a combination of IRAs) is $5,500 a year, depending on the person’s adjusted gross income. These contributions are invested into a fund that grows compound interest over time. In some instances, a person may decide to withdraw the money early. For those who have kept a Roth IRA for at least five years and are over age 59.5, there is typically no penalty and the withdrawals are not taxed. With a traditional IRA, any early disbursements are given a 10 percent penalty, plus a tax liability at the investor’s current tax rate.
Another type of investment for retirement is the 401k retirement plan. A 401k is very similar to an IRA, but it is offered exclusively through an employer. To avoid the complication of the tax deduction at the end of the year, 401k contributions are usually made pre-tax. Employers may choose to partially or completely match employee contributions up to a certain amount, typically 3–6 percent. Younger workers can contribute up to $18,000 per year. This money is put into a fund managed by a third party designated by the employer. The employees retain some degree of control over the contributions they make personally.
The company may follow a vesting schedule for any contributions the employer makes on an employee’s behalf. For example, an employer may choose to give employees full vesting of its contributions to the plan, or increase vesting over time. Workers who are not fully vested when they end employment with the company may only be able to keep a portion of the employer’s contribution. When people choose to withdraw the money early, they face the same taxation and penalties as a traditional IRA.
Certain companies do not have the option of creating a 401k for their employees, and many of them are eligible to start a 403b instead. A 403b is fundamentally similar to a 401k, except it is designed for people who work in education or certain tax-exempt industries. Like a 401k, an employer can accept contributions from employees and match those contributions to a certain limit. Since these contributions are made prior to taxation on income, people pay taxes on it once they start taking disbursements. In addition, an employer may set a vesting schedule on its contributions. Like a 401k, the maximum personal contribution is currently set at $18,000 per year.
How Much Should I Contribute?
The best amount to contribute is unique, depending on the time left before planned retirement, the level of diversification in a portfolio, and the kind of life a person plans to lead once they quit working. Experts suggest that people plan to have a nest egg large enough to cover 80 percent of their pre-retirement expenses. Social Security will probably still be around in some form, but many people find that Social Security alone is not enough to cover a reasonable life in retirement. Because of this, it’s better to develop your investing skills now.
It can be exciting to watch a retirement fund grow once the money has been put in, much like watching your home appreciate in value while you build equity. With an understanding of the different types of retirement plans, investors can set retirement goals and see how well their money works for them.