Thinking of saving money for your golden years? Good thinking. You’re never too young to start stuffing the coffers. Two popular retirement investment vehicles worth considering are the 401(k) and the traditional IRA (or individual retirement account). What's the difference? Simply put, a 401(k) is a retirement savings plan offered through your employer. An IRA is something you set up yourself with help from your bank, brokerage firm or mutual fund company.
To 401(k) or not?
If your company offers a 401(k), contribute to it, especially if your employer matches what you put in. Some companies match as much as 6% of your salary dollar-for-dollar. That’s free money! Don't turn it down. Your own contributions to the plan are taken from your paycheck on a pre-tax basis, which can mean more money for you. Eventually, Uncle Sam gets his due, but that’s only when you start withdrawing funds from your 401(k), after years of the interest in your plan growing tax-free. When you do start tapping into the money, you pay income taxes – at your current income tax rate at the time. Think you’ll be pulling in a power salary as a retiree? Probably not. So don’t touch the 401(k) until you retire and are in a considerably lower income-tax bracket. That said, if you have to borrow from your 401(k) (say you have a medical emergency), you can. As long as you pay it all back, you can avoid any fines, nasty letters or robo-calls.
Of course there are a few strings attached, including how much you can sock away every year. For 2013, the limit is $17,500 if you’re 49 or younger, and $23,000 if you’re 50 or older. There are rules for getting your hands on the money, too. Touch it before you turn 59 ½, and you’ll be slapped with a penalty if you don't pay it back. Likewise, you need to begin withdrawing before you’re 70 ½. The only other caveat with a 401(k)s is this: Find out what your contributions are being invested in. Even if your investment choices are limited, you should know what they are and be ready to make changes when and where you can. Why? It’s not uncommon for a company to invest a sizable chunk of its 401(k) plan in its own stock. Then what happens if the company goes down in flames? Think Enron. (Or any of the companies that have imploded since then.) Bye-bye savings.
The skinny on IRAs
An Individual Retirement Account, or IRA, is a way for you to save money for retirement that has nothing to do with an employer-sponsored 401(k). You set up your own IRA (with a little help from your bank or financial planner) and, ideally, deposit money into it every year. While you don’t get any matching contributions with an IRA, you usually have more investment choices – things like stocks, bonds, mutual funds and Certificates of Deposit (CDs). If you track your investments and don’t like how they’re performing, you can rearrange them.
As with a 401(k), the amount you contribute to your IRA is deducted from your taxable income, and you don’t pay the piper until you start making withdrawals. Unlike a 401(k), however, you can’t borrow from an IRA. (There is a complicated option, which requires opening a new account so you can move money from your IRA to the new account – and then you only have 60 days before you have to re-deposit the money back into the IRA. Unless you have several IRA accounts with plenty of money in each, this rigmarole isn’t worth it.)
Like 401(k)s, IRAs impose contribution limits, although they’re much lower. For 2013, if you’re 49 or younger, you’re limited to $5,500; if you’re over 50, you can contribute up to $6,500. One nice perk about putting money in your IRA: You can do it until tax filing day of the following calendar year. In other words, you have until April 15 of next year to sock it away.
Rollovers and Roths
Remember Roth IRAs? Contributions to a Roth IRA are not tax-deductible (you pay taxes on it upfront), but withdrawals are totally tax-free. That’s right. No taxes on earnings. Period. In fact, you may want to roll your IRA into a Roth IRA. You can do that now regardless of income or marital status. (Prior to 2010, only those account owners who had a modified adjusted gross income below $100,000 were eligible to convert.) While we're talking rollovers, it's worth noting that if you leave a job where you had a 401(k), rolling it over into an IRA is usually the best option - especially if you aren't going somewhere new that offers a 401(k).
This has been updated from the original version, which was published in 2009.