How Do I Make Sense of Retirement Savings Plans?

If you don’t have the retirement savings you want, one of the barriers you face is likely to be understanding all of the crazy, nonsense terms you think you need to understand just to open an account. There are really just four key words to understand in the retirement planning arena. That’s it.

How Do I Make Sense of Retirement Savings Plans

Four: IRA: Individual Retirement Arrangements more commonly called IRA’s are accounts defined by the Internal Revenue Service (IRS) as having special status that excludes the income on the account from your taxable income each year (in some cases, only until you retire). You can open an IRA with virtually any bank, credit union, or brokerage.

401k: A 401k is much like an IRA, except that your employer opens the account and holds the money for you. You have the option of contributing some of your income into the 401k (you can’t be forced to participate) and the income on the investments in the 401k are excluded from your income at least until retirement.

Traditional: Both IRAs and 401ks come in two varieties, the first of which is called “Traditional”because it was invented first. A traditional IRA or 401k is one in which your contributions to the account can be deducted from your current year’s income on your tax return. In other words, if you contribute $ 5,000 in 2012, that $ 5,000 will be deducted from your taxable income, reducing the tax you pay this year. Furthermore, you’ll pay no tax on any income earned in the account until you withdraw it for retirement income after age 59 1/ 2. When you withdraw it during retirement, you’ll pay tax on it then.

Roth: Again, both IRAs and 401ks come in the “Roth”variety. Roth variety accounts make the money in the account never, ever subject to tax, provided that it stays in the account until you retire. The catch is that there is no tax deduction in the year of your contribution, making it more difficult to get started. If you have a 401k at work but don’t think you’re saving enough, you can simply contribute more to your 401k. Very few people bump up against federal limits on contributions to a 401k. You don’t need to have an IRA, too. If you don’t have a 401k, go to virtually any financial institution and open an IRA. If you are likely to have more than $ 10,000 within a year, go to a stock brokerage like Schwab, Fidelity or TD Ameritrade. If it will take a few years, just get started at your local bank or credit union.

Traditional or Roth? If you pay a very low tax rate now, go with the Roth as your future income will likely be taxed at a higher rate and the deduction isn’t worth much this year. If you are taxed at a very high rate (congratulations, you earn a lot), you’ll likely want to contribute to Traditional accounts. Still have questions? Your tax accountant and the folks at the bank or brokerage can help. Go see them.

Why Should You Contribute to Your 401k?

Before answering the question, why contribute to your 401k, let’s first answer the question, what is a 401k? A 401k is a retirement savings plan with associated tax benefits offered by your employer. A 401k is an account into which you, principally, and your employer (perhaps) secondarily both contribute. The money that you contribute is always yours and can never be forfeited due to a change in your employment status. You can, however, lose money on investments, but leaving your job won’t cause you to lose your hard earned money.

There are two types of 401k accounts, “traditional”and “Roth.”Many, but not all, employers offer both.

1. Traditional: Traditional 401k accounts offer a tax deduction for contributions. Withdrawals will be taxed when withdrawn during retirement.

2. Roth: Roth 401k accounts do not offer a tax deduction for contributions, but the withdrawals during retirement are not taxed at all. While many people get excited about the idea of the Roth—no income tax during retirement—the value of that difference is limited to the difference in tax rate between now and retirement. If you have low enough income—or enough children—that you pay little or no tax on your income now, then it makes perfect sense for you to contribute to the Roth type account. If you have high income as some do at the pinnacle of their careers, it may make more sense to contribute to a traditional account to shelter income in the high tax year and pay tax in retirement when income may drop you into a lower tax bracket. The key reason to contribute to your 401k, regardless of which account type you choose, is to save money for your retirement. Investment returns for the current generation are likely to be lower than for the last generation, meaning that we’ll need to invest more than our parents to have the same sort of retirement. More than ever, we need the benefit of what the finance world calls “compound returns.”That simply means, we need the benefit of the interest on the interest piling up over the years to provide for our retirement. The secondary reason to contribute to your 401k is that your employer is probably going to contribute to the account. If you contribute $ 1,000 this year, your employer will likely give you another $ 500 to $ 1,000 as well. The money contributed by your employer is typically subject to vesting, meaning that if you leave within a defined period of time, you’ll lose the money the company contributed on your behalf and the earnings on it. Still, that means you could get a raise just for making a contribution to your 401k—which you should do anyway. It’s basically free money. Never pass up free money!

How to choose between a Roth IRA or a Traditional IRA

There is no absolute right or wrong answer to choosing between a Roth IRA and a Traditional IRA, but there are some things you should think about that may alter your decision from one year to the next. Keep in mind that the same tax rules apply to traditional and Roth 401ks as well as IRAs. By way of reminder, contributions to a traditional plan are deductible in the year of the contribution (reducing your current year tax) and withdrawals during retirement are taxed at your then current tax rate with all other taxes deferred. Contributions to a Roth plan are not tax deductible, but the withdrawals are never taxed if held until retirement. The guiding principle is that you want to avoid the bigger tax. If you think your tax rate this year is higher than your tax rate in retirement, you’ll want to contribute to the traditional plan. On the other hand, if you think you’ll have a higher rate in retirement than you will this year, you’ll want to contribute to the Roth plan. As a general rule, you’ll want to contribute to the traditional plans in years where you pay an unusually high tax rate (say, you get a big bonus or exercise stock options). You’ll want to contribute to the Roth plans in years you have an unusually low tax rate (business losses, gap in employment, etc.). In many years, however, there will be no special tax situation. By splitting your contributions between the two plans, you’ll create some flexibility during retirement. By using some money from the Roth each year in retirement, you may be able to effectively reduce the tax rate on the money you are forced to withdraw from the traditional IRA. Of course, some people believe that the national debt will force future tax rates to be much higher than current rates. If you expect to have the same taxable income in retirement that you have now, it would be wise to invest in the Roth IRA as a hedge against those potentially higher tax rates. On the other hand, while tax rates are likely to be somewhat higher in the future, most people won’t save enough to have the same income in retirement that they have during their working years. You may be in that situation. Your retirement income could leave you in a lower tax bracket than you’re in today—even if tax rates in general are higher. For instance, many people today are in the 28 percent tax bracket; many are also taxed in the 15 percent tax bracket. Even if those brackets move from 28 and 15 to 31 and 18 percent respectively, if your income drops you to the lower tax bracket in retirement, you’ll have been better off contributing to the traditional plan and getting the 28% deductions all those years and then paying the 18% tax. In conclusion, you need to assess your situation each year to see if there is a fact or circumstance that dictates a switch from your general strategy. If outcomes for you are unclear, the safest bet is to split your contributions between the two plans.

Above article is a a source from Book 925 Ideas to help save money , get out of debt and retire a millionaire. Copy righted to Devin.

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