Retirement planning is essential given the ever-increasing life expectancy in the United States. Unfortunately, many Americans fail to save adequate amounts to make it through retirement. Often, individuals believe that they will be fine on Social Security. However, Social Security is only designed to compensate for 40% of your income; Social Security is designed to be an income supplement rather than a sole income source. To make matters worse, workers tend to overestimate how late into their life they will be able to work. Inadequate savings and an inability to work produce an exceptionally stressful retirement. Remember, it’s never too late to start saving.

401(k) Plans

401(k) plans are employer-sponsored retirement plans that offer tax advantages to investing. When investing through a 401(k) plan, you will declare how much of your paycheck you would like to contribute to the 401(k). The employer will then contribute the designated amount before taxes to your 401(k) account. The contributions made to your 401(k) account are non-taxable meaning that your taxable income is decreased by the amount contributed. As of 2018, the maximum amount that a taxpayer can contribute to a 401(k) account is $18,500. The tax advantages of the 401(k) plan mean that if the taxpayer earns $80,000 annually in salary and contributes $10,000 to his or her 401(k) plan, then the taxpayer’s taxable income for that year would be decreased to $70,000. When the taxpayer begins to withdraw from the 401(k) account, those withdrawals will be treated as taxable income.

However, money contributed to a 401(k) plan may not be withdrawn before the age of 59.5 without incurring a penalty unless certain exceptions apply. Unfortunately, not all employers offer 401(k) plans. If your employer doesn’t offer a 401(k) program, make sure to take advantage of other retirement plan options such as a Traditional IRA or a Roth IRA.

Traditional and Roth IRA

The Traditional IRA functions very similar to a 401(k) plan except that it does not have to be employer-sponsored. This means that if your employer doesn’t offer a 401(k), or you’d like to contribute more than the 401(k) contribution limit, you can set up a Traditional IRA. From a tax perspective, a Traditional IRA functions the same as a 401(k): the amounts contributed are not taxed and distributions are taxed.  However, unlike a 401(k), the contributions to your Traditional IRA are made by you. As a result, whatever you contribute to your Traditional IRA will then be deducted from your taxes when you file.

Conversely, contributions to a Roth IRA are made after tax (they aren’t tax deductible) but the withdrawal is not treated as income. Whereas a 401(k) or Traditional IRA defer taxes until you withdraw, a Roth IRA allows you to pay the tax on the contribution and then withdraw from the account tax free. For the Traditional IRA and Roth IRA, you cannot withdraw without a penalty before 59.5 years of age. As of 2018, the normal contribution limit for IRA accounts (Traditional + Roth) is $5,500, meaning that you cannot contribute more than $5,500 between the two.

Due to the complexity of retirement plan options and tax consequences, retirement planning can be difficult and time consuming. To better plan for your future, speak with an experienced estate planning near you.