The vast majority of Americans that contribute to retirement plans do so through either a defined contribution plan (the 401(k) being the most widespread and most well-known), an Individual Retirement Plan (IRA) – either Traditional (tax-deferred) or Roth (tax-exempt) – or a combination of the two.
Defined contribution plans such as the 401(k) offer at least one distinct benefit and one potential benefit. The benefit? The money you contribute to a defined contribution plan is done so on a pre-tax basis, meaning your annual tax liability is reduced. The potential benefit? If your employer provides matching contributions, free money is put to work for you.
As with a 401(k), a Traditional IRA offers a tax-deferred benefit. Compare that to a Roth IRA which is tax-exempt, meaning you will not realize a tax benefit in the year contributions are made. Instead, the tax benefit is realized when withdrawals are made.
My preference? If an employer offers a 401(k) plan (contribution limit = $17,500 for those 49 and younger; 50 and older can add an additional $5,500 in catch up contributions), employees should first strive to contribute enough to capture any matching contributions in that tax-deferred type of plan.
Second, SavvyInvestors should then open a Roth IRA account (contribution limit = $5,500 for those 49 and younger; 50 and older can add an additional $1,000 in catch up contributions), a tax-exempt type of plan. Having retirement money in different types of accounts provides more flexibility with respect to taxes when the time comes to develop – and execute – a withdrawal plan.
Of course, the goal for SavvyInvestors would be to get to the point of maximizing contributions to both.
This week’s SavvyPoll asks, “Are you currently contributing to a retirement plan(s)?”
B. Yes – a 401(k) plan
C. Yes – an IRA (Traditional or Roth)
D. Yes – both a 401(k) and an IRA