Investing in your future is always a good idea, and there are lots of ways to do it. Whether you have a 401k plan through your employer or an individual retirement account (IRA), or both, there are a range of investment opportunities at your fingertips.
There are two types of retirement plans we discuss here – IRAs and 401ks. The type of retirement plan you choose depends partly on your eligibility to participate, but more so on how you choose to invest. There is no one-size-fits-all retirement plan or strategy.
What is an IRA?
IRA stands for individual retirement account. Rather than using a retirement plan through an employer, an individual works directly with an investment firm. Individuals investing in their own IRA can continuously add money to an account via a brokerage which is then used to purchase investments, like stocks, mutual funds, bonds, etc.
Roth vs Traditional IRA
Roth IRA
With a Roth IRA, you make post-tax contributions to the plan so you cannot deduct your contributions to the plan on your taxes (because of that your money grows tax-free). If you follow the rules, then you can withdraw funds penalty-free when you are ready to retire. You can contribute to a Roth IRA after age 70 ½, unlike a traditional IRA.
There are limitations on who can participate in Roth IRAs. In general, those who can contribute, either up to the limit, a reduced amount, or nothing (zero), include the following:
| Filing Status | Adjusted Gross Income (AGI) |
|---|---|
| Single or Head of household |
Less than $120,000 |
| $120,000 - $134,999 | |
| Greater than $135,000 | |
| Married filing jointly |
Less than $189,000 |
| $189,000 - $198,999 | |
| Greater than $199,000 | |
| Married filing separately |
Less than $10,000 |
| Greater than $10,000 |
Via the IRS
For more info on calculating your reduced amount, click here.
Traditional IRA
With a traditional IRA, you contribute pre-tax money to the plan, and then pay taxes when you withdraw the funds in retirement. You can get a tax deduction for contributions with a traditional IRA. When you contribute pre-tax dollars, your taxable income is reduced by however much you contributed that year. So, say your salary is $50,000 and you contribute $10,000 to your IRA, then your taxable income would be $40,000 so you would owe less on your income taxes. In order to participate in an IRA, you must earn an income and be under the age of 70 ½.
Difference between Roth & IRA accounts
The main difference between a Roth IRA and a Traditional IRA is when the individual pays taxes on their retirement investments. Roth IRA taxes are paid prior to investing, whereas Traditional IRA taxes are paid when withdrawing funds after the investment has matured.
The decision between the two types of retirement accounts should be evaluated on a case-by-case scenario. Traditionally, people decide on a traditional IRA because they intend to make less money in retirement than when they are working. Therefore, the individual will have a lower taxable income and may even drop to a lower tax bracket in retirement. On the other hand, Roth IRAs take all uncertainty out of the equation. The biggest uncertainty is the tax rate. The tax rate might be higher or it might be lower when you retire. By paying pre-tax through a Roth IRA, the investor knows the exact tax rate they will pay on their retirement funds.
Is there a maximum you can contribute to a traditional or Roth IRA in a year?
For 2020 and 2021, the maximum you can contribute to a traditional or Roth IRA is $6,000. Those 50 years and older can contribute $1,000 extra each year, for a total of $7,000. However, if you choose to rollover contributions from a 401k into an IRA, the limit does not apply to those funds.
What is a 401k plan?
A 401k is a retirement savings plan sponsored by an employer, unlike an IRA. Employees can invest pre-tax dollars from their paychecks into the plan and withdraw the funds when they retire. Taxes are paid when the funds are withdrawn. Employers can match their employees’ contributions up to a certain percentage i.e. 50 cents on the dollar up to 3% of an employee’s contribution. Some plans/employers make new hires wait before they can enroll and begin contributing to the plan. Generally, a third party administrator (like Fidelity or Charles Schwab) will facilitate the transactions and manage plan performance, paperwork, etc.
In most cases, when you get a 401(k) through an employer that offers matching, employees must vest, meaning they must work for a certain amount of time before they are eligible to receive employer contributions. So it could be a few years before you start receiving employer match contributions. Whenever you decide to leave the company, you can take the money you’ve saved with you, by rolling it over to a personal IRA.
Is there a maximum you can contribute to a 401k plan in a year?
There are annual maximum contribution limits for 401k plans. For 2020 and 2021, you can defer up to $19,500 to a retirement savings account. For people 50 years old and older, the 2020 and 2021 limit is $26,000 per year with catch-up contributions. Employer matching contributions do not count towards the maximum.
If you have multiple retirement plans, like a 401k plan through your employer and an IRA on your own, and you contribute to both regularly, the maximum you can contribute in a year for 2020 is $57,000 (catch up at $63,500) and raises to $58,000 in 2021 (catch up $64,500).
What are “catch-up” contributions?
Catch up contributions are for those who have started contributing to a retirement savings account later in life and want to contribute more money over a shorter period of time in order to “catch-up.” The IRS allows for “catch-up” contributions so you can do just that. Individuals 50 and older can contribute additional money at the end of each calendar year. For 2020 and 2021, the limit is $6,500 extra (on top of the $19,500 regular max contribution level) each year, for a total of $26,000 per year.
XcelHR offers a retirement plan for business owners who want to help their employees plan for the future. Find out more about XcelHR’s MEP plan here.
