Optimal ways to save for retirement at work: 401(k) plans and IRAs

Saving for retirement helps you to prepare for a more secure future, and it’s never too early in your career to start. One great way to begin is to take advantage of the special benefits provided by retirement accounts. Retirement accounts offer a tax break on your savings — either initially, or later, when you withdraw funds.  And some plans even receive matching funds from your employer.

How to get started

Your first step should be contributing to an employer-sponsored retirement plan, like a 401(k).  The name comes from the section of the tax code —subsection 401(k). After giving your company permission to set aside a portion of your earnings to be automatically deducted from each paycheck, those funds will be invested in an account for your retirement.  As an incentive, employers often match these savings (typically 50 cents on the dollar), up to a certain percentage of your contribution.

Depending on the type of retirement account you select, you receive a tax break either when contributing money up front, or when withdrawing it at retirement. Make sure you’re putting enough away to take advantage of your full employee benefit, the company match.

Traditional 401(k) vs. Roth 401(k)

The two main types of 401(k) plans are the traditional and the Roth. Each has its own distinct tax advantage. Not only that, both investment vehicles have an employee contribution limit up to $19,500, per year in 2021; and $20,500, per year in 2022.  (Those who are age 50 and above can contribute an additional $6,500 per year).  Growth is achieved through the underlying assets’ increase in value or capital gains. Income is earned from interest or dividends, which are usually reinvested for compounding income.   

Traditional 401(k)

Contributions to a traditional 401(k) plan are taken from your paycheck before the money has been taxed. This lowers your adjustable gross income for that year.  For example, if you earn $70,000 and put $19,500 into your 401(k), instead of paying income taxes on the entire $70,000, you’ll owe tax on only $50,500 of your salary. The tax is withheld as ordinary income when funds are withdrawn from your 401(k) plan, usually during retirement or at 59½ years of age.

 Roth 401(k)

On the other hand, contributions to a Roth 401(k) are made up front, with post-tax dollars.  Down the road, at the time of withdrawal, you will not be obligated to pay tax on that money because your obligation to the Internal Revenue Service has already been fulfilled before the monies were deposited.)  Since withdrawals are tax-free, a Roth 401(k) may be the better option if you think your tax rate will be higher when you retire. Also, since withdrawals can be made any time, unlike a traditional IRA, a Roth 401k might provide more flexibility. Just remember, in order to invest the maximum allowed into a Roth IRA ($20,500 in 2022), your income must be below a certain level.

Choosing an IRA

If you don’t have access to an employer sponsored 401(k), or if you want to save more than what’s allowed, open an IRA through an investment firm. IRAs offer thousands of underlying investment options, compared to the typical 15 to 20 funds chosen by the 401(k)’s plan administrator. They come in both traditional and Roth versions and allow investments of up to $6,000 per year in 2021 and 2022. (An additional $1,000 is allowed for those age 50 and above).

A major factor in determining which IRA to choose is to determine your tax rate when it’s time to retire. When determining your tax bracket (see table below), consider your Social Security benefits, pensions, investments, retirement plans and other sources of income you anticipate receiving during retirement.

Income limits to invest the maximum amount in a Roth IRA

----Modified adjusted gross income----

                                        2022                              2021

Single tax filer           below $129,000              below $125,000 

Joint tax filer             below $204,000              below $198,000

Why a Roth IRA?

Choose a Roth IRA if you expect to be in a higher tax bracket in retirement.  For those who qualify, a Roth IRA may be the better choice given its more flexible, early withdrawal rules and fewer restrictions for retirees.  Contributions can be withdrawn at any time, tax- and penalty-free.  This is in contrast with the traditional IRA and traditional and Roth 401(k)s, for which withdrawals typically start at age 59½.

Maximize your retirement investments with a 401(k) and an IRA

It may make sense for you to invest in both investment vehicles, thereby diversifying your assets and reducing your investment risk. To take advantage of your employer’s match to the 401(k) and the flexibility and choice of an IRA, consider the following strategy:

1. Enroll in your company's 401(k) and contribute the amount your employer will match.
2. Open an IRA and contribute the $6,000 maximum allowed to your IRA.
3. Return to your 401(k) and contribute beyond the company match to the annual maximum limit, if possible.

Changing or leaving your job

If you’re switching jobs, or you’re not ready to retire, but are leaving your job, there are several options for your 401(k) money:

• Roll over your funds to an existing or new IRA at an investment firm
• Roll over your plan to your new employer’s 401(k) plan
• Keep your funds in your former employer’s 401(k) plan
• Take a cash distribution. (If you withdraw money before the age of 59½, you’ll be required to pay the IRS a 10% early withdrawal penalty and income tax on the distribution.)

Before deciding what to do, consider if the plan charges 12b-1 operational fees. The variety of investments offered and its underlying rules.

Looking forward

Investment plans, including 401(k)s and IRAs, were created by the government to help citizens save for retirement.  By aiming to put away 15 percent of your pre-tax income into retirement accounts, you can maximize your hard-earned dollars and lay the groundwork for a bright financial future.

To learn more about opening an IRA, call 866-919-4520 to speak with a Citizens Financial Advisor.