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It can be difficult to know when to start thinking about retirement. Especially having just begun a career, saving money for a retirement years away can be tough to consider. However, the sooner one starts saving for retirement, the better!
Many businesses — especially larger ones — offer their employees a type of investment account called a 401(k) plan. Through automatic payroll deductions, money is not only saved for them: often a portion of the amount contributed by the employee is matched by the company! The deduction is taken before earnings are taxed, and no taxes are due on the amount saved until the year the employee’s distributions are withdrawn. This type of account is opened and managed by the employer, although the employee usually has a choice of several investment options designed to meet their specific needs.
Although the traditional 401(k) plan is a sensible solution when available, there are other investment accounts available and one would be wise to learn about them all to make the right decisions for their needs.
In 1974 Congress introduced the IRA for people who had no employer or company plans. Similar to the 401(k), but an individual would open this account, choose where to invest their money and manage the account to their own choosing, with financial advisers available if desired. Like the 401(k), the distributions would not be taxed until withdrawn, and contributions may be eligible for an income tax deduction if a retirement plan is not otherwise available to the contributor.
A Senator from Delaware named William V. Roth sponsored an additional type of investment account that now bears his name in 1998 as part of the Tax Relief Act of 1997. His type of IRA plan (called a Roth IRA) allows for paying taxes the year of the contribution and withdrawing distributions tax free at a later date. This type of plan allows a younger worker to pay tax in a lower tax bracket than what it may be when he retires, with the assumption that his tax bracket would be higher in retirement. This is a very attractive option, since it allows investments to grow tax-free, and income tax will never have to be paid on that growth.
Now, to add to the mix, the Roth version has been added to the 401(k) plan also. Not all employers offer this option, but the Roth 401(k) investment plan is a combination of the traditional 401(k) plan with the elective of being taxed in the year of contribution and not being taxed at all when distributions are taken, if age requirements and other IRS limits are met. Any matching funds by the employer are not included in the individual’s limitations.
In the United States, there are four predominantly common types of retirement investment vehicles: the traditional 401(k), the Roth 401(k), the traditional IRA, and the Roth IRA.
The major differences between the 401(k) and IRA accounts are the way you contribute, who manages the investments and tax considerations. The difference between a traditional and Roth option is how taxes are paid on contributions and investment growth.