It is becoming more and more common for employees not to have access to an employer-sponsored 401(k) plan, leaving millions left to fend for themselves. According to an article from The Motley Fool, approximately one out of every three Americans doesn’t have a retirement savings plan in place. If you have any desire to retire sometime down the road but don’t currently have a retirement savings plan, it’s imperative that you become proactive. But what is the best place to stash your cash?
Many are turning to either an IRA or an annuity for their retirement savings needs. And while both are great financial tools, it’s really important to understand the differences between them so that you can better make a decision for your unique situation. Here’s a look at the basics of each and how they stack up in comparison.
One of the best perks of the traditional IRA is that the money you deposit usually goes in tax-free. Growth is also tax-deferred for as long as your money remains in the account. Once you start withdrawals in retirement, your distributions are then taxed as ordinary income. There’s a wrinkle however; if you make any withdrawals before the age of 59 1/2 , you’ll suffer a 10% early withdrawal penalty that you’ll also have to be taxed on. So, it’s ill-advised to take money out of your IRA early, but on the flip-side, you can’t leave it in too long either. Once you turn 70 ½, you’ll be forced to start taking minimum distributions (based on your account balance and life expectancy). If you don’t take your required minimum distributions on time, you’ll be hit with a 50% penalty on the amount you fail to withdraw.
Currently, you can contribute up to $5,500 a year to an IRA before reaching the age of 50. Individuals who are 50 and older can contribute up to $6,500.
Annuities haven’t been as popular as IRAs historically, mainly because they are a bit more complex. But there are definitely some benefits that retirees can take advantage of. While you can’t contribute to an annuity with pre-tax dollars, once you fund your contract, your money grows on a tax-deferred basis until withdrawals begin. Just like an IRA, you can’t take any money out of an annuity before the age of 59 ½ without being penalized, though there are a few exceptions. One of the biggest benefits of annuities is that there’s no limit to contributions. You can deposit as much much as you’d like and take full advantage of the tax-deferred growth. Be aware though that annuity withdrawals aren’t totally tax-free. Annuities are taxed on a last-in, first-out basis, so when you start taking distributions, the money that’s first withdrawn is considered earnings and therefore taxed as ordinary income. Once your annuity balance falls below the amount you paid in principal contributions, your withdrawals become tax-free.
Additionally, you are not required to start taking minimum distributions at any certain age. This can be especially beneficial if you are still working at the time and don’t need the money yet.
So, which one is right for you?
This isn’t an easy question to answer, and you’ll need to carefully consider which features are most important to you. Here is a concise table, (from the Motley Fool article) that compares the similarities and differences between the two.
|Annual contribution limit||$5,500 if you’re under 50; $6,500 if you’re 50 or older||No annual limit|
|Earliest withdrawal age to avoid penalties||59 ½ (exceptions apply)||59 ½ (exceptions apply)|
|Required minimum distributions||Starting at 70 1/2||No required minimum distributions|
|Tax treatment of contributions||Contributions are made with pre-tax dollars||Contributions are made with after-tax dollars|
|Taxes on withdrawals||Withdrawals are taxed as ordinary income||Withdrawals are taxable initially, but eventually become tax-free|
If you simply can not decide between these two retirement savings tools, remember that they do not need to be mutually exclusive. If you have enough in savings to max out your annual IRA contributions with some leftover, consider putting the excess cash into an annuity.
Regardless of the option you choose, the key is to develop a retirement savings plan as soon as possible. By starting now, your dream of retiring some day may actually become reality.
Written by Rachel Summit