401k & IRA Investments for Retirement

This article is going to expand on our retirement planning article, focusing on 401k and IRA options. Cap Credit ™ will help you secure a short term loan but our long term goal is to help you secure your financial future so you won’t need our help. There is some awesome information in this article so please take this opportunity to learn how you can help yourself.

Why You Need To Plan
Basics of 401(k)
401(k) Contributions and Distributions
Basics of an IRA
Different Types of IRAs
Conclusion

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Why You Need To Plan

Uncertainty about the continuance of Social Security has been in the air for many years now. There are very clear indications that Social Security payments can no longer be counted upon as guaranteed income during your retirement years. A future retiree may, at best, get a portion of what he can actually claim as Social Security. At worst, the entire system may simply be wiped out by increasing pressure. Whatever the final fate of Social Security, it is evident that retirement planning is no longer an option but a necessity.Image of 401K nest egg

With recession and taxes having a negative impact on conventional savings and investments, it is best to focus on tax-advantaged savings schemes and plans to create your retirement fund. Plans such as 401(k)s and IRAs are growing in popularity among Americans who have realized that a company pension plan may go belly up during the next recession.

Tax Advantage

IRA and 401(k) plans offer a savings tool that gives you many added advantages. They allow you to save for your future through tax deferred deposits, thus maximizing the amount that you can actually put away. By stashing away the money that you would otherwise have paid Uncle Sam, you earn an interest on this sum too. When compounded, this amounts to a good addition to your retirement fund.

When it’s time to withdraw from your savings, taxes do apply. But the good news is that post- retirement, you may fall within a lower tax bracket. Withdrawals made during that time incur a lower tax rate so you end up paying less tax in the end. There are some plans that also allow you to make tax-free withdrawals.

Employer Contribution

Many of these plans receive a matching contribution from your employer as well. Companies use 401(k)s as a means of rewarding loyal employees and sharing their profits. In many cases, your contribution to your 401(k) may be matched dollar for dollar by your employer. In effect, you get free money just by making sure that you save for your retirement.

Structured Savings Plan

A 401(k) or IRA is a great way to streamline your finances and establish a structured savings system wherein a portion of your monthly earnings is set aside for the future without fail. Contributions to these plans are deducted directly from your salary in many cases, so that there is no risk of accidentally missing payments or spending the money.

Adapt to Career Changes

Even when you change jobs or quit your employment to set up your own business, you can still continue to get the benefits of your retirement plans when you opt for 401(k)s and IRAs. Unlike company-sponsored pension plans, these do not necessarily need to be terminated when you make career changes.

The many advantages and the great flexibility offered by these plans make them a popular choice for retirement planning among Americans. It is, however, necessary to understand the various conditions that apply to making contributions and withdrawing funds from these plans before you set up one.


Basics of 401(k)

401(k)s are the most popular plans used for retirement saving in the U.S. They are comprehensive plans, packed with many advantages, as well as being flexible enough to be used by all employed persons. For employees who are looking for a safe and simple retirement saving option, the first and most obvious choice is a 401(k). This plan is available to most people who have completed at least a year in the service of an employer.

How Does it Work?

The 401(k) is a plan that allows employees to opt for direct transfer of a portion of their salary into a special retirement savings account. This is a government-regulated, qualified plan.

For the employer, any contributions made to employee 401(k)s are deductible on his income tax return, subject to some limitations outlined in the section 404 of the Internal Revenue Code.

Often, the employee’s contribution into his/ her 401(k) is matched partially or fully by the employer, subject to certain limitations. So, for every dollar you put into your 401(k), your employer may add 50 cents, effectively multiplying your savings. However small the employer contribution, it is still free money for you to add into your retirement fund. Your employer can also choose to make contributions above and beyond this predetermined match.

The tax benefit is one of the most attractive features of a 401(k) plan. The contributions you make into your plan are tax deferred; that is, you do not pay tax on this amount in the year it is earned. For example, if you earn $5,000 a month and your total contribution to your 401(k) is $1,000, then your taxable income is $5,000 – $1000 = $4,000. Your tax payable is calculated only on $4,000. Your contributions are not shown, even as part of your taxable income, when you submit the form 1040. This is why it is recommended to make the maximum possible contribution to your 401(k) plan each year.

However, contributions are taxed at the time of withdrawal. During retirement, your income is much lower than when you are drawing a regular salary. Owing to this, a lower tax rate may be applicable at the time of withdrawal in retirement.

You can choose to have your contributions taken after tax, so that you pay taxes on these funds in the year that you earn them. In this case, your withdrawals from the 401(k) are not taxed. However, your 401 (k) plan terms and conditions must allow this change.

Where Do Your 401(K) Investments Go?

The funds in your 401(k) account are invested in various instruments like CDs, term deposits, mutual funds, equity, etc. You have a great deal of control over how your funds are invested. You can make a choice about the percentage of funds invested in various options.

Your employer also has a say in determining the kind of investments that are available in your 401(k) for you to choose from. Even if the choices are highly limited or they do not match your investment strategy at all, it is still a good idea to save some of your salary with a 401(k) to gain the other benefits that this plan affords. You can simply opt for the least risky of the investment choices and park your funds here until retirement.

Your 401(k) plan document will have a comprehensive list of the investments from which you can choose. You can change your preferences at any time. In this way, you can start with higher risk investments in the early years of your career to gain higher returns. In the later years, as you approach retirement, you can simply change your investment pattern so that your funds are diverted into conservative investments.


401(k) Contributions and Distributions

A 401(k) is a defined contribution plan. This means that the final sum that you can withdraw from your plan depends on your contribution and also on the performance of your investments. In effect, a 401(k)’s performance is largely in your hands. If you want to save a reasonable sum to make your retired life anxiety-free, you can choose to make adequate contributions as well as plan your investments so that you get good returns with the least risk.

Making Contributions

An employee can make a maximum annual contribution of $16,500 into his 401(k) plan. The limit for joint contributions in which the employer matches the employee’s contributions is set at $49,000. The employer contribution includes all manner of deposits by the employer, including but not limited to matching contributions.

For employees aged above 50, the maximum annual contribution is higher because they can make extra contributions of $5,500. For these employees, the maximum total employer- employee contribution is set at $54,500.

For all your contributions within these limits, you can defer the tax payable on this portion of your salary in the current year.

Required Minimum Distributions

401(k) account holders are required to take distributions from the account from the age of 70 ½. Those who are still working at this age have the option of postponing these distributions until their retirement.

Withdrawals from 401(K)

The 401(k) is designed to provide funds when you are retired and, because of this, there are some restrictions on withdrawing funds from this plan before retirement. Withdrawals or distributions, as they are called, can be made when:

  • The date of termination of the plan has arrived according to the plan document.
  • At the age of 59 ½
  • When the employee retires, resigns, experiences a disability, or upon his death.

In addition, some plans allow hardship withdrawal. The employee can draw funds when an event classified as hardship can be proven to have occurred. Premature withdrawals made when none of these conditions exists draw a 10% penalty. These will be considered as ordinary income in the year of withdrawal.

Loans from the 401(K)

You can also take a loan from your 401(k). Again, as these funds are intended for post-retirement use, restrictions do apply. Your employer’s approval for the loan is mandatory. Some other conditions apply as well:

  • No more than 50% of the vested balance can be taken as loan.
  • A maximum of $50,000 is the ceiling amount for loan. Even if 50% of your vested balance exceeds this ceiling, your loan amount cannot.
  • You have to replenish the funds taken as a loan within the succeeding five year period.

Interest is charged on the loan you take, even though it is your own money. The loan is treated as part of your 401(k), which will continue to be shown on the books with full value. This is in contrast to withdrawals wherein your 401(k) is reduced by the amount withdrawn.

If you fail to repay the loan or any portion of it at the end of the five year period, this portion is considered a withdrawal. Any penalties that may apply on premature withdrawals will apply on this amount. These factors make it evident that a 401(k) should not be your first choice as a source of loans for people with bad credit if any expenses crop up before the age that you can make withdrawals without penalty.

Limitations of a 401(k)

There are some limitations to a 401(k) plan, the most important of which is that the employee cannot set up one on his own, i.e., without the employer’s assistance and approval. Also, the investment options are restricted to the choice offered by the employer. For employees who either fail to qualify for a 401(k), whose employer does not offer such a plan or who are unhappy with the investment choice, an IRA is a good option to save for retired life.


Basics of an IRA

Individual Retirement Accounts or IRAs present a wonderful opportunity for tax-free savings to those who cannot access a 401(k). Those whose employer does not offer 401(k) or who are ineligible for these prefer to save with IRAs instead. In fact, an IRA offers greater freedom in terms of being able to pick and choose desirable investments that make up your retirement fund. This makes it a good option for those whose 401(k) have very limited choices.

How to Open an IRA?

Anyone under the age of 70 ½ who earns an income that is taxable in the year can open and contribute to a traditional IRA. These accounts can be opened in banks or brokerage houses by the individual through a simple process. In some cases, your employer may open an IRA account on your behalf.

The simplicity of setting up the account and the ease of its operation make this savings plan comparable to 401(k)s. There are many types of IRAs, in addition to the traditional type such as Roth IRAs, SEP IRAs, Simple IRAs, etc., that have different features and terms.

To make IRA contributions, you should have earned compensation that falls within the list of eligible earnings. These include salary/ wages, commission as a sales percentage, and tips.

Tax Advantages

Contributions to your IRA account are tax deferred and you can deduct these contributions from your taxable income in the year when the contribution is made. At the time of withdrawal, the distributions are taxed. Roth IRA is an exception to this rule and the contributions are paid with after-tax dollars. Consequently, withdrawals from a Roth IRA are tax-free.

Where Are IRA Funds Invested?

A wide range of investment choices are available when you opt to save with an IRA. These include stocks, bonds, treasury bills, CDs, mutual funds, real estate and even complex financial products such as derivatives. When compared with 401(k)s, the array of options is much wider and allows much greater leeway in choosing a plan that matches your risk appetite.

Of course, certain limitations are imposed by law where IRA investment options are concerned. For example, insurance products or illiquid assets like paintings or sculptures are not allowed as part of an IRA investment plan. These restrictions come into play because the IRA is designed to provide accessible, inflation protected funds during retired years.

Life insurance products do not provide insulation against inflation. Illiquid assets cannot be easily converted to cash, nor can their conversion price be predicted with accuracy. That is why such products are disallowed for investment with your IRA funds.


Different Types of IRAs

There are many variations available with Individual Retirement Accounts. Each of these comes with its own set of features and characteristics that make it suitable for people with different needs.

Traditional IRA

A traditional IRA is a simple tax deferred retirement savings plan. At the time of withdrawal, when you may fall within a lower tax bracket, tax applies on the amounts withdrawn.

You can contribute up to 100% of your yearly compensation to your traditional IRA in any year. Catch up payments in excess of this amount are allowed for IRA holders above age 50. Contributions to spousal IRAs can also be made when the spouse is not an earning member or earns a negligible amount.

It is possible to transfer funds from another retirement plan into your traditional IRA. When you stop working for an employer who offers a retirement plan to join another who doesn’t, you can simply have your 401(k) balance transferred into an IRA. Rollover of distributions received from other retirement plans into your traditional IRA is also allowed.

When the traditional IRA holder reaches the age of 70½, he/she has to start taking required minimum distributions as a lump sum or as a yearly installment. Remember that any distributions not taken in a particular year or before due date will attract a substantial accumulation penalty.

Funds can be withdrawn from your traditional IRA beyond the age of 59½ without penalty. Distributions taken before this age are subject to a 10% penalty except when they are used under special circumstances to pay for the following expenses:

  • Medical treatment that is not reimbursable
  • Medical insurance
  • Disability
  • Education
  • Distributions to beneficiary
  • Home purchase

It is important to note that some conditions apply on the use of traditional IRA funds for these purposes. If you intend to withdraw funds from your IRA account, it is best to first check if your need qualifies for a penalty-free withdrawal.

SEP and Simple IRA

These are IRAs established by employers on behalf of their employees. Self-employed persons and small business owners often opt for these plans. Employees can opt to directly transfer a portion of their salary to the plan before tax. Employers may add a tax deductible contribution to the employee’s IRA plan with these retirement plans. Both the employer’s and the employee’s contributions are taxed only at the time of distribution. The rules that apply to traditional IRA contributions and distributions are largely applicable to these plans too.

Roth IRA

The most significant difference between a Roth IRA and a traditional one is that Roth funds and earnings accrue tax-free; that is, contributions are made with after-tax dollars so that no tax applies on distributions. Typically, distribution conditions and contribution terms are very similar to those of traditional IRAs.

However, it is important to note that certain types of distributions, classified as non-qualified distributions, may attract tax as well as a penalty for premature withdrawal. It is essential that you understand the taxation terms before you take distributions from your Roth IRA before they are due. Beneficiaries of a Roth IRA should keep in mind that Required Minimum Distributions apply to them and not to the individual who established the Roth IRA.


Conclusion

RAs and 401(k) plans offer a tax-advantaged tool to maximize what you can save for your retirement. Making optimum use of these plans helps you establish and maintain a structured financial plan for your retired years. Even if the investment options allowed under these plans are not in line with your overall investment strategies, it is advisable to participate in these plans to a certain extent to gain the substantial benefits that they offer.

By doing so, you don’t just enhance your savings by contributing before-tax dollars, but also qualify for free contributions from employers.

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