Traditional IRA, Roth IRA, 401(k), 403(b): What's the Difference?
The earlier you begin planning for retirement, the better off you will be. However, the problem is that most people don’t know how to get started or which plan is the best vehicle to get you there.
A good retirement plan usually involves more than one type of investment account for your retirement funds. This may include both an IRA and a 401(k), allowing you to maximize your planning efforts.
If you haven’t begun saving for retirement yet, don’t be discouraged. Whether you begin through an employer sponsored plan like a 401(k) or 403(b) or you begin a Traditional or Roth IRA that will allow you to grow earnings from investments through tax deferral, it is never too late or too early to begin planning.
This article discusses the four main retirement savings accounts, the differences between them and how Saxon can help you grow your nest egg.
“A major trend we see is that if people don’t have an advisor to meet with, they tend to invest too conservatively, because they are afraid of making a mistake,” said Kevin Hagerty, a Financial Advisor at Saxon Financial.
“Then the problem is they don’t revisit it, and if you’re not taking on enough risk you’re not giving yourself enough opportunity for growth. You run the risk that your nest egg might not grow to what it should be.”
“Saxon is here to help people make the best decision on how to invest based upon their risk tolerance. We have methods to determine an individual’s risk factors, whether it be conservative, moderate or aggressive, and we make sure to revisit these things on an ongoing basis.”
Traditional IRA vs. Roth IRA
Who offers the plans?
Both Traditional and Roth IRAs are offered through credit unions, banks, brokerage and mutual fund companies. These plans offer endless options to invest, including individual stock, mutual funds, etc.
Eligibility
Anyone with Earned, W-2 Income from an employer can contribute to Traditional or Roth IRAs, as long as you do not exceed the maximum contribution limits. However, only qualified distributions from a Roth IRA are tax-free.
In order to be able to contribute to a Roth IRA, you must have taxable income and your modified adjusted gross income is either:
- less than $194,000 if you are married filing jointly
- less than $122,000 if you are single or head of household
- less than $10,000 if you’re married filing separately and you lived with your spouse at any time during the previous year.
Tax Treatment
With a Traditional IRA, typically contributions are fully tax-deductible and grow tax deferred. So when you take the money out at retirement, it is taxable. With a Roth IRA, the contributions are not tax deductible but grow tax deferred. So when the money is taken out at retirement, it will be tax free.
“The trouble is nobody knows where tax brackets are going to be down the road in retirement. Nobody can predict with any kind of certainty because they change,” explained Kevin. “That’s why I’m a big fan of a Roth.”
A Roth IRA can be a win-win situation from a tax standpoint. Whether the tax brackets are high or low when you retire, it doesn’t matter. Your money will be tax free when you withdraw it. Another advantage is, at 70 ½, you are not required to start taking money out. “We’ve seen Roth IRAs used as an Estate planning tool, and they’ll be able to take that money out tax free. It’s an immense gift,” Kevin said.
Maximum Contribution Limits
Contribution limits between the Traditional and Roth IRAs are the same; the maximum contribution is $6,000, or $7,000 for participants 50 and older.However, if your earned income is less than $6,000 in a year, say $4,000, that is all you would be eligible to contribute.
“People always tell me, ‘Wow, $6,000, I wish I could do that. I can only do $2,000.’ Great, do $2,000,” said Kevin. “I always tell people to do what they can and then keep revisiting it and contributing more when you can. If you increase a little each year, you will be contributing $6,000 eventually and not even notice.”
Withdrawal Rules
With a Traditional IRA, withdrawals can begin at age 59 ½ without a 10% early withdrawal penalty but still with Federal and State taxes. The IRS will mandate that you begin withdrawing at age 70 ½.
Even though most withdrawals are scheduled for after the age of 59 ½, a Roth IRA has no required minimum distribution age and will allow you to withdraw contributions at any time. For example, if you have contributed $15,000 to a Roth IRA, but the actual value of it is $20,000 due to growth, then the contributed $15,000 could be withdrawn with no penalty, any time – even before age 59 ½.
Employer Related Plans – 401(k) & 403(b)
A 401(k) and a 403(b) are theoretically the same thing; they share a lot of similar characteristics with a Traditional IRA as well.
Typically, with these plans, employers match employee contributions, such as .50 on the dollar up to 6%. The key to this is to make sure you are contributing anything you can to receive a full employer match.
Who offers the plans?
One of the key differences with these two plans lies in whether the employer is a for-profit or non-profit entity.
These plans will have a number of options of where to invest, often a collection of investment options selected by the employer.
Eligibility
401(k)’s and 403(b)’s are open to all employees of the company for as long as they are employed there. If an employee leaves the company they are no longer eligible for these plans since 401(k) or 403(b) contributions can only be made through pay roll deductions. However, you can roll it over into an IRA and then continue to contribute on your own.
Only if you take possession of these funds would you pay taxes on them. If you have a check sent to you and deposit it into your checking account – you don’t want to do that.
Then they take out federal and state taxes and tack on a 10% early withdrawal penalty if you are not age 59 ½. It can be beneficial to roll a 401(k) or 403(b) left behind at a previous employer over to an IRA so it is in your control, and you have increased investment options.
Tax Treatment
Contributions are made into your account on a pretax basis through payroll deduction.
Maximum Contribution Limits
The maximum contribution is $19,500, or $26,000 for participants 50 and older.
Depending on the employer, some 401(k) and 403(b) plans provide loan privileges, providing the employee the ability to borrow money from the employer without being penalized.
Withdrawal Rules
In most instances, comparable to a Traditional IRA, withdrawals can begin at age 59 ½ without a 10% early withdrawal penalty. The IRS will mandate that you begin withdrawing at age 70 ½. Contributions and earnings from these accounts will be taxable as ordinary income. There are certain circumstances when one can have penalty free withdrawals at age 55, check with your financial or tax advisor.
In Conclusion…
“It is important to make sure you are contributing to any employer sponsored plan available to you, so you are receiving the full employer match. If you have extra money in your budget and are looking to save additional money towards retirement, that’s where I would look at beginning a Roth IRA. Then you can say you are deriving the benefits of both plans – contributing some money on a pretax basis, lowering federal and state taxes right now, getting the full employer contribution match and then saving some money additionally in a Roth that can provide tax free funds/distributions down the road,” finished Kevin.
To learn more, contact Kevin Hagerty today at (513) 333-3886 or via email at khagerty@gosaxon.com.
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Paving the Road to a Successful Portfolio
Determining a proper asset allocation is an important first step in creating your portfolio and planning how it will grow in the future. Asset allocation is the process of diversifying your investments into different asset classes based on the investor’s time horizon, their goals and how much risk they can tolerate.
“People always ask me what they can invest in that will make them a lot of money without the chance of losing any,” said Brian Bushman, Saxon Financial Advisor.
“I tell them that this simply doesn’t exist. But I can, however, help them design an optimized portfolio based on their risk tolerance and what they are trying to accomplish.”
Whether you’re just beginning to save for retirement or you’re much further down the road with more substantial savings, asset allocation is the result of understanding your comfort with risk and how to best diversify your investments to accomplish your goals.
The key to asset allocation is diversification. This allows an investor to take advantage of investing in many different opportunities which can reduce their overall risk.
Assets can be allocated either strategically or tactically. A strategic plan sets a target allocation and consistently rebalances that allocation back to the original percentages while a tactical plan focuses on adjusting the portfolio based on current economic conditions and opportunities in order to produce a better risk adjusted return. Brian and the investment team at Saxon bring a hybrid approach to designing and managing their investor’s portfolios.
Many investors only consider the returns on their investments, but it is very important to assess the level of risk a portfolio is taking to achieve that return. Saxon’s approach is to optimize this risk vs. return ratio.
It is also important for investors to understand there are different types of risk. Most associate risk with investment risk which is the risk of losing money.
However, there are many other risk factors to consider. Inflationary risk, interest rate risk, credit risk, taxability risk, currency risk and legislative/political risk are other types of risks that need to be considered when developing a portfolio.
Below are the three main factors needed in designing a suitable portfolio for the client.
3 Factors in Designing a Suitable Portfolio
1. Time Horizon
The amount of time that you have to reach your goals should directly impact the level of risk you are willing to take. When you’re young you have much more time to recover from any losses that could be incurred from a drop in the market, but as retirement approaches you have less time to recover from market losses.
The closer you get to retirement, the more you should consider reducing your risk level. Once you retire and need income from your investments you may need to redesign your portfolio from an accumulation portfolio to an income portfolio.
2. Risk Tolerance
Typically, investments that have the potential to generate higher returns are riskier. This is where the idea of risk tolerance comes in. This refers to the amount of volatility an investor can tolerate.
If your risk tolerance is low, then you will likely earn a lower return. To compensate for a lower anticipated return, it is important to evaluate the amount you are investing and possibly adjust your timeline accordingly to reach your goals. Usually gauged by a questionnaire, risk tolerance is often used to categorize investors as aggressive, moderate or conservative.
3. Goals
Each person’s goals are different, whether you are working towards a long-term goal of retirement or a short-term goal, you should consider these goals in your asset allocation plan.
One person’s ideal asset mix could be completely wrong for someone else. Outside of setting financial goals and an ideal retirement goal, it is important to set a goal to adjust investments as you age.
“There is no crystal ball that provides insight on how to best allocate assets. It’s a process that begins with an initial risk assessment, diversifying your investments and continually monitoring the progress of your portfolio,” said Brian Bushman, Saxon Financial Advisor.
How Saxon Helps
A Saxon investment advisor can provide guidance through the process of creating a well-balanced portfolio.
For more, contact Brian Bushman today at (513) 333-3901 or bbushman@gosaxon.com.
Too Many Choices?
Source: ThinkHR.com
Some of the earliest investment advice given: “Don’t put all of your eggs in one basket.” Its value is enduring. An investor can minimize the risk of losing money by diversifying the allocation of money into different categories of investments. Even within a single category, an investor can choose investment vehicles, such as mutual funds, spreading ownership over an array of financial instruments. Are plan sponsors successful if they offer participants the highest possible amount of mutual funds and other investment choices?
Offering a large number of funds does not equate to success in either the realm of compliance with regulation, nor in achieving maximum levels of employee participation. It is important to offer the appropriate number of choices to empower participants to meet goals for retirement income. It is also important to do this in a manner that allows the employer to meet fiduciary responsibilities.
Fiduciary Responsibility
On one hand, participant-directed accounts, such as many 401(k) plans, give members control over their own investment accounts. On the other hand, the plan sponsor is generally still responsible for the fiduciary liability associated with selecting and monitoring the investment vehicles being made available to participants. Good processes with solid documentation of their application provide the foundation, enabling employees to make good decisions about investments. These factors also position the employer to face an Employee Benefits Security Administration (EBSA) audit without undo fear of negative consequences. Most employers will need to engage the services of a “prudent expert” as a guide along the path of selecting and monitoring appropriate investment opportunities.
A prudent expert financial advisor must be familiar with methods required to deliver comprehensive analysis of investment vehicles. Among these methods is the necessity to establish and track appropriate benchmarks to measure a particular investment’s performance over time. Understanding the purpose of a particular class of investments and how the particular fund being offered relates to its peers is more important than offering a large number of funds in that class.
Sponsors need to maintain an Investment Policy Statement outlining the categories of investments to be offered to participants. This document should also identify the committee and entities responsible for choosing, monitoring, and, when appropriate, replacing the individual investment options offered to participants. This tool will assist the sponsor in seeing when it is appropriate to replace an option instead of just adding new options. Beyond concerns about managing an employer’s exposure to liability, providing a reasonable, yet limited, choice of options can actually improve employees’ willingness to participate in the benefit plan.
Participant Behavior
Fewer choices are better when people do not come into a situation already knowing for sure what they prefer. This describes most employees in their relationship to employee benefit plans. They simply do not know what to do without education. Initially, it may seem logical to grant the widest possible range of options. If surveyed, employees may even indicate a strong preference for unlimited choices. However, the employer’s goal is not to merely capture interest — the goal is to make it easy for employees to participate in a benefit plan and see progress towards fulfillment of their own financial objectives.
The opportunity to make some choices is a good thing for participants. Indeed, it is necessary for employees with participant-directed accounts to be offered options so that they can achieve diversification of their investments. However, too much of a good thing is manifest when participants experience choice overload.
Behavioral scientists are finding choice overload to be a condition people experience when they withdraw from a situation out of fear of making the wrong decision. Often an individual starts off highly motivated as they begin to examine the choices they have been presented. As choice overload sets in, the extensive array of choices becomes demotivating, and the individual may put off a decision to commit or give up entirely.
Sheena S. Iyengar of Columbia University and Mark R. Lepper of Stanford University demonstrated the impact of choice overload when they studied the influence of choice on the purchasing habits of 502 people who were introduced to various selections of exotic jams. They found that 60 percent of the people given the opportunity to choose from 24 items were interested in investigating, but only 3 percent made a purchase. By contrast, only 40 percent of those given the limited choice of 6 items investigated, but 30 percent made a purchase. The average quantities of jam individuals were willing to taste test was less than 2, regardless of whether they were offered an array of 6 or 24.
Employers can promote participation in benefit plans by reducing the complexity of presentations to employees. Making use of competent advisors, employers can present employees with properly labelled choices packaged in a consumer-friendly manner.
