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401k's, IRAs and Roth's, what do they all mean?

If your a US citizen or US expat, the sheer number of retirement and savings options out there can be overwhelming at times. With members of the public vying for each side as the one stop solution. However as we discuss below, each of these retirement vehicles have their own benefits and drawbacks associated and sometimes may not be the best options available.


What is a 401(k)?

  • A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account.


  • While a 401(k)can help you save, it has plenty of restrictions and caveats. In most cases, you can’t tap into your employer’s contributions immediately. Vesting is the amount of time you must work for your company before gaining access to its payments to your 401(k). (Your payments, on the other hand, vest immediately.) It is an insurance against employees leaving early. On top of that, there are complex rules about when you can withdraw your money and costly penalties for pulling funds out before retirement age.

Who is eligible for a 401(k)?

  • You must be 21 years of age


  • You must be a full-time employee, who has served up to a year of service. If you meet this criteria, your employer must allow you to participate in a company-matching qualified retirement plan. Not all employers make employees wait a full year before enrolling (the longest allowable time by law).


What are 401(k) contribution limits?

  • 401(k) contributions offer more fiscal freedom than an IRA. The IRS updated the contribution limits for 401(k) plans in 2020 on Nov. 6, 2019, increasing the employee contribution from $19,000 to $19,500. Other important increases that went into effect for 2020: The catch-up contribution rose to $6,500.


  • 401(k) distributions tax


  • Contributions to a 401(k) are pre-tax, which means you don't pay taxes until you withdraw money from the plan. This may be attractive for those who expect to be in a lower tax bracket during retirement than during their working years. In addition, your contributions have the potential to grow on a tax-deferred basis.


  • As with IRAs, non qualified withdrawals from a 401(k) before the age of 59½are subject to a 10% Federal income tax penalty, unless a qualified exception applies. Some employers may also offer a Roth 401(k) option, which allows workers to make Roth IRA-type contributions to their 401(k) plan without the income restrictions and lower contribution limits that apply to Roth IRAs. The contribution limits are the same as for traditional 401(k)s, but salary deferrals to Roth 401(k)s are not tax deductible. Qualified distributions are tax free.



Traditional IRA vs Roth IRA


Contributions

Perhaps the biggest difference between traditional IRAs and Roth IRAs is how and when taxes apply to the contributions and earnings. Contributions to traditional IRAs can be pre-tax (deductible on the taxpayer’s income tax return). Although contributions and earnings accumulate on a tax-deferred basis, income taxes are due when IRA distributions are taken. On the other hand, contributions to Roth IRAs are made with after-tax dollars, and contributions and earnings accumulate tax free. No income tax is due when distributions are taken from a Roth IRA. For tax year 2014, the maximum contribution to either a traditional IRA or Roth IRA is $5,500 ($6,500 for individuals age 50 or older).


Age Restrictions

Contributions to traditional IRAs may be made in the years in which an individual receives compensation prior to attaining age 70½. Required minimum distributions (RMDs) must begin by April 1 of the year after an individual reaches age 70½ (or a considerable tax penalty may apply). In contrast, Roth IRAs have neither an age limit for contributions nor minimum distribution requirements. However, both traditional and Roth IRAs have a minimum age for distributions: 59½. Distributions taken prior to age 59½ may be subject to a 10% Federal income tax penalty. Certain situations qualify as exemptions, such as distributions to pay first-time-home buyer expenses or qualified education expenses. Furthermore, before tax-free distributions can be received from a Roth IRA, the account must be five years old.


Income Eligibility Limits


Depending on your tax-filing status, your income, and whether or not you participate in a qualified employer-sponsored retirement plan, you may be eligible to take an income tax deduction for contributions to a traditional IRA. If you are a single taxpayer, it is often not worthwhile to participate in a qualified employer-sponsored plan, and earn a minimum of $5,500, contributions are deductible regardless of your adjusted gross income (AGI). However, if you do participate in an employer-sponsored retirement plan, income limits apply. Deductions in 2014 phase out for single filers with modified AGIs (MAGIs) between $60,000 and $70,000, and for married couple joint filers with MAGIs between $96,000 and $116,000.


The Income Eligibility

Requirements are different for Roth IRAs. If you participate in a qualified employer-sponsored retirement plan, you may contribute to a Roth IRA; however, if you are also contributing to a traditional IRA, your contributions may not exceed the annual contribution limits. You are eligible to make a full contribution to a Roth IRA if your MAGI in 2014 does not exceed $129,000 for single filers or $191,000 for married joint filers (contributions phase out for single filers with MAGIs between $114,000 and $129,000, and for married joint filers with MAGIs between $181,000 and $191,000).


For a married individual filing separately who participates in a workplace retirement plan, the phase-out range is $1 to $10,000. A Roth IRA is often a favoured choice for those who participate in a qualified employer-sponsored retirement plan and exceed the income limits for a deductible IRA, but who meet the income eligibility requirements for a Roth IRA


Savings Accounts


We've all come across a savings account at one point in our lives, and as the names implies these are very straightforward accounts offered by many leading institutions. However what may not be known by many savvy individual is how to best utilise their savings accounts and avoid bad habits. Especially with interest rates foretasted to remain low for the foreseeable future, keeping too much in a savings account could erode your purchasing power over the course of time due to inflation.



  • A savings account is an interest-bearing deposit account held at a bank or other financial institution. Though these accounts typically pay a modest interest rate, their safety and reliability make them a great option for parking cash you want available for short-term needs. Savings accounts have some limitations on how often you can withdraw funds, but generally offer exceptional flexibility that’s ideal for building an emergency fund, saving for a short-term goal like buying a car or going on vacation, or simply sweeping surplus cash you don’t need in your checking account so it can earn more interest elsewhere.


  • Savings and other deposit accounts are an important source of funds that financial institutions can turn around and lend to others. For that reason, you can find savings accounts at virtually every bank or credit union, whether they are traditional brick and mortar institutions or operate exclusively online.


  • In addition, you can find savings accounts at some investment and brokerage firms. The rate you’ll earn on a savings account is generally variable. With the exception of promotions promising a fixed rate until a certain date, banks and credit unions can generally raise or lower their savings account rate at any time. Typically, the more competitive the rate, the more likely it is to fluctuate over time. Changes in the federal funds rate can also trigger institutions to adjust their deposit rates. And some institutions offer special high-yield savings accounts, which are also worth investigating.


Advantages


  • Savings accounts offer you a place to put your money that is separate from your everyday banking needs, allowing you to stash money for a rainy day or earmark funds to achieve a big savings goal. What’s more, the bank’s security measures, along with federal protection against bank failures provided by the Federal Deposit Insurance Corporation (FDIC), will keep your money safer than it would be under your mattress or in your sock drawer.


  • Beyond keeping your funds safe, savings accounts also earn interest, so it pays to keep any unneeded funds in a savings account instead of accumulating cash in your checking account, where it will likely earn little or nothing. At the same time, your access to funds in a savings account will remain extremely liquid, unlike certificates of deposit, which impose a hefty penalty if you withdraw your funds too soon.


  • Holding a savings account at the same institution as your primary checking account can offer several convenience and efficiency benefits. Since transfers between accounts at the same institution are usually instantaneous, deposits or withdrawals to your savings account from your checking account will take effect right away. This makes it easy to transfer excess cash from your checking account and have it immediately earn interest—or transfer money the other way if you need to cover a large checking transaction.


  • Many institutions allow you to open more than one savings account, which can be handy if you want to keep track of your savings progress on multiple goals. For instance, you could have one savings account to save for a big trip while a separate one holds surplus cash from your checking account.

Disadvantages

  • The trade-off for a savings account’s easy access and reliable safety is that it won’t pay as much as other savings instruments. For instance, you can earn a higher return with certificates of deposit or Treasury bills, or by investing in stocks and bonds if your time horizon is long enough. As a result, savings accounts present an opportunity cost if used for long-term savings.


  • Also, while the liquidity of a savings account is one of its key benefits, it can also be a downside, as the ready availability of funds may tempt you to spend what you’ve saved. In contrast, it is much more difficult to cash in a bond, withdraw funds from a retirement account, or sell a stock than it is to take money out of your savings account, especially if that account is linked to your checking account.


  • Savings accounts are also a poor choice for funds you need to access frequently. If you’ll need to make withdrawal transactions more than six times per month—whether those are transfers or outright withdrawals at a branch or ATM—a savings account is not an appropriate vehicle for these funds.


Get a complimentary copy of the American expat guide at https://www.dunhillfinancial.com/american-expat-financial-guide for more information about the financial planning process and to find out which retirement options are right for you, visit www.dunhillfinancial.com.


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