Wednesday, 5 April 2017

Retirement planning is a vital component of setting yourself up for a comfortable life after you finish working.

The earlier you start saving, the better off you will be, thanks in part to the power of compound interest—something Albert Einstein supposedly once referred to as the eighth wonder of the world.

Deciding on a retirement plan to choose, whether it's a 401(k), traditional IRA, or Roth IRA, can be a daunting and confusing proposition. Here, we break down the pros and cons for each option.

401(k) Plans

401(k) plans are provided by an employer to an employee. Not all employers offer 401(k) plans, but those that do make deductions from an employee's paycheck to deposit into the plan as savings for retirement. You are allowed to start taking money out of your 401(k) without penalty when you are 70½ years old.  According to IRS stipulations, you must start your retirement distribution by April of the year that you turn 70½.

PROS:

  • Most 401(k) plans are made pre-tax, thereby reducing your taxable income for a year.
  • Many employers offer 401(k) matching programs. These initiatives vary depending on the company, but some offer 50 cents on every dollar an employee contributes into his or her plan, up to 6 percent of that employee's salary. Others offer a more generous matching option while some businesses don't provide one at all.

CONS:

  • Many employers require employees to wait before investing in their 401(k). Eligibility dates can vary from three months after an employee's first day to up to a year. Ask your human resources representative for the length of time you may have to wait to start contributing.
  • It's important to know that most 401(k) contributions are made before tax, which means you will be taxed when you make a withdrawal.

Roth IRAs

Roth IRAs, which are individual retirement accounts, are a very popular retirement savings tool. Established in 1997 and named after the late Delaware State Senator William V. Roth, Roth IRAs are funds that hold after-tax contributions. You can withdraw money after you turn 59 ½ years old.

PROS:

  • Roth IRAs allow people to withdraw money tax-free, since tax is already paid up front. This is a huge benefit, especially if you think your tax rate may increase significantly by the time you get to retirement. In that case, it can be optimal to pay a lower tax rate when depositing into a Roth IRA, so you don't have to pay higher taxes later.
  • You are allowed to contribute up to $5,500 ($6,500 if you are 50 or older) or 100 percent of your employment compensation—whichever is the lesser amount.

CONS:

  • You can take out up to $10,000 for first-time home buyer expenses without a penalty, but you must wait at least five years after your first contribution to the account.
  • Not everyone can deposit money into a Roth IRA, since the IRS posts income limitations every calendar year. For 2015, those who qualify to deposit money into such an account must have made less than $131,000 gross income (individual) or $193,000 (couple filing jointly).
  • You cannot get a tax break on Roth IRA contributions because you are paying taxes up front.

Traditional IRA

A traditional IRA is a savings plan that allows you to contribute money, either pre-tax or after-tax. Like the Roth IRA, you can make withdrawals after you turn 59 ½ years old.

PROS:

  • You get a tax deduction on contributions. This leaves money in your pocket in the short term. However, you will need to pay taxes when you take out your money in retirement.
  • Unlike Roth IRAs, Traditional IRAs do not have income limits to make contributions.
  • You are allowed to contribute up to $5,500 ($6,500 if you are 50 or older) or 100 percent of your employment compensation—whichever is the lesser amount.

CONS:

  • Traditional IRAs require that you pay income taxes when you withdraw your money.
  • You will be forced to pay a 10 percent tax penalty if you decide to withdraw money before you turn 59 ½ years old. That penalty is also applied even when you have financial hardship, such as the loss of a job.

 

The content provided is for informational purposes only. Neither BBVA Compass, nor any of its affiliates, is providing legal, tax, or investment advice. You should consult your legal, tax, or financial advisor about your personal situation. Opinions expressed are those of the author(s) and do not necessarily represent the opinions of BBVA Compass or any of its affiliates.

Links to third party sites are provided for your convenience and do not constitute an endorsement. BBVA Compass does not provide, is not responsible for, and does not guarantee the products, services or overall content available at third party sites. These sites may not have the same privacy, security or accessibility standards.