Saving for retirement is essential because, as we all know, living isn’t cheap, so if you want to position yourself to no longer need a steady stream of income, then you need to start saving (and the sooner, the better). For most of us, saving for retirement isn’t challenging to understand. But all of the different ways you can (or can’t) do it is where things get a little complex.
Once upon a time, many companies would set their employees up with pensions, which are retirement savings accounts that the employer significantly contributes to (employees can also put money into these plans, but the employer pays the bulk). Pensions have various pay-out methods, but the idea is that if you’re loyal to a company, they’d be returning the favor by setting you up financially for retirement. Unfortunately, today pensions are rare and if a company offers any kind of retirement savings plan at all, it’s through a 401(k).
To complicate things even more, not every company offers a 401(k), or if they do, they might not provide it to every employee. So, what does someone do if they don’t have access to this kind of retirement savings account? That’s where individual retirement accounts (IRAs) come in. To add to the confusion, 401(k)s and IRAs are not mutually exclusive, which means you can also have both simultaneously.
It’s a lot to take in, and the best route for you may not be the most obvious one. It’s essential to understand the basics to make a decision that works for you and your goals.
Retirement Savings 101
While there are still some organizations that offer pensions (particularly for those working in public service) and special retirement savings programs for small business owners/self-employed people, the two most commonly used types of retirement plans are IRAs and 401(k)s. These accounts both have the same purpose, to save for retirement, and offer tax benefits, but they are still quite different.
There are two types of IRAs: a traditional IRA and a Roth IRA. Both types of accounts are opened and fully funded by individuals. Employers do not offer or contribute to them. They differ from traditional savings accounts because the money in them can be invested in different stocks and bonds (meaning you can make more money by simply putting money into them).
A traditional IRA allows anyone with earned income to make contributions to the account pre-tax. This is a significant advantage, but it’s important to note that you will be taxed on it at that point (regular income tax rate). While you can withdraw from an IRA before age 59 ½, you will be taxed and likely incur a hefty penalty for doing it (here are the rules and exceptions).
Roth IRAs are different in that there is no up-front tax benefit to contributions because anything you put into it will be taxed first. Because of this, though, when you withdraw your money after age 59 ½, you will not be taxed on it. Additionally, if you need to withdraw money from the account before you’re 59 ½, you may be able to avoid taxes and penalties (here are the rules and exceptions).
Pros and Cons of IRAs
PRO: As long as you or your spouse has earned income, you do not need an employer to open one
PRO: Roth IRAs allow you to pass money to your kids/heirs tax-free
PRO: Usually easy to set up and manage (many credit unions and other organizations offer clients access to IRAs at no cost)
PRO: Traditional IRA provides tax benefits
PRO: Some flexibility for early withdrawals
CON: Low annual limit to how much you can contribute (2022: $6,000 limit for anyone under age 50 and $7,000 limit for anyone 50+)
CON: Tax benefits may differ based on your income and if your employer offers a retirement account
CON: Traditional IRAs have required minimum distributions starting at age 72
Thanks to The Revenue Act of 1978, corporations can provide retirement benefits to employees through 401(k)s instead of pensions (so that’s why pensions were slowly phased out in the 1980s and 1990s). Today, there are two types of 401(k)s: traditional and Roth. Both types of accounts are employer-sponsored and offer employees the convenience of having their contribution taken directly from their paycheck and put into their retirement account. Some companies that provide 401(k) accounts to their employees contribute to those accounts, either independently or match up to a certain percentage of each check.
Currently, no federal requirement says a company has to offer a 401(k) to its employees, but some states do have mandates around this benefit. If a company does offer a 401(k), there are federal rules they have to follow. One of the most notable rules is that companies have to provide access to a 401(k) to all employees who are at least 21 years old and have worked for the company for at least one year, regardless of whether they are employed part-time or not full time. (Note, companies can require two years of service before an employee is eligible for employer contributions, but all employees are 100% vested in employer contributions after two years of service).
A traditional 401(k) allows an employee to contribute a portion of their salary into a savings account on a tax-free basis (meaning, this money is taken out of your paycheck pre-tax). By using an employer-sponsored 401(k), employees can invest their savings into stocks/mutual funds with potentially high returns (so, they’ll save money and have the potential to earn money at a higher rate than they would in an IRA).
Since this is a tax-deferred account, you cannot withdraw from it penalty-free until you are at least 59 ½ years old. After you reach 59 ½, any money withdrawn from the account will be taxed at regular income rates. If you decide to withdraw money early, any amount you take will be subject to federal and state income tax, plus you’ll be charged a 10% fee. However, some situations allow penalty-free withdrawals from your 401(k) and many providers offer 401(k) loans in which you pay yourself back with after-tax earnings.
Employers may offer employees access to a Roth 401(k), which is similar to a Roth IRA in that any contributions are made after-tax. Your money will grow over time. Once you turn 59 ½, you can withdraw your contributions and earnings tax-free. The funds can be withdrawn from this account before 59 ½ penalty-free if the account owner is disabled or has passed away (in which case, the funds will go to their beneficiaries). You can still withdraw from the account before age 59 ½. Still, it’s an unqualified withdrawal to pay income taxes and a 10% penalty fee on any earrings you made (you will not be taxed on the money you contributed since it was taxed before investing).
Pros and Cons of 401(k)s
PRO: Tax benefits
PRO: Higher annual contribution limits (2022: $20,500 for anyone under 50 years old, $27,000 for anyone 50+)
PRO: Possible employer match
PRO: There are no income stipulations for tax benefits
PRO: Option to borrow penalty-free with a loan (if plan permits)
PRO: Automatic payroll deductions
CON: Not all employers offer the Roth option
CON: You may not be fully vested in employer contributions until you’ve been employed for two years
CON: No control over investment options
Choosing The Best Retirement Option
You’re fortunate if your employer offers you a 401(k), matching contribution, and a Roth 401(k) access. Plus, you still also can open traditional and Roth IRAs (though the tax benefits of a traditional IRA may differ in this situation). So, what do you do?
If your employer offers you a 401(k) match (or any contribution), take advantage of that first, because it’s sort of like free money (not like pensions were back in the day, but we’ll take what we can get, right?). From there, the best financial advice for your specific situation will come from a financial advisor. Many employers offer financial services as a benefit, either solo or through Employee Assistance Programs (EAPs), so it’s worth looking into your benefits package. You may also have access to a financial advisor if you’re a credit union member. If you don’t have quick and easy access to anyone, look into free or low-cost options through non-profit organizations. If you want to establish a long-term relationship with a financial advisor, ask around your community for recommendations so that you’re paired with someone trustworthy and with a reputable company.
Retirement Resources for Women
It is a lot to take in, and it’s only scratching the surface of what you need to know to set yourself up for retirement. If you want to do a little more studying, here are some women-targeted resources to check out:
If you are able, you need to start saving for retirement sooner than later – even if it’s a traditional saving account through your bank. Every penny counts, and while retirement seems far off now, by the time you reach 59 ½, you’ll probably be ready to start the next chapter of your life, but it won’t be near as fun or relaxing if you’re broke. So, do some research and seek guidance if you need to enjoy your golden years.
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