As you start the plan for your retirement, understanding the difference between 401k and IRA accounts will be helpful. Although both are common ways to save and invest for your future, each offers distinct advantages.
Today we will take a closer look at both of these types of retirement accounts. Plus, how to include the best fit in your retirement plans.
What is a 401k?
First, let’s take a closer look at a 401k.
A 401k is an employer-sponsored plan
The first thing to know is that 401ks are employer-sponsored retirement plans. Many companies offer access to these retirement accounts as a perk of working with them.
You can set up a portion of your paycheck to be automatically contributed to your 401k. When you do this, you’ll enjoy the fact that your contribution is made with your pre-tax dollars.
Additionally, some employers will send contributions to your 401k. This is known as a company “match.”
Typically, the employer will clearly share what their matching policy entails. In some cases, you might enjoy a full match of your contributions up to 3%.
In others, you might receive a match for half of the funds you contribute. The rules will vary by the company, but it should be relatively easy to find this information.
If you aren’t sure whether or not your company offers a 401k, then check with Human Resources to find out. They’ll have all the details you need to set up an account.
Accounts similiar to a 401k
If you aren’t able to contribute to a 401k, don’t worry!
There are other employer-sponsored retirement accounts that you might be eligible for.
A few include a 403(b) and a 457(b). Even without any of these employer-sponsored plans, you still have options to build your retirement savings.
How much can you contribute?
If you are eligible to contribute to a 401k, there are some limitations on how much you can contribute. It is important to note that these limits are set by the IRS, not your employer.
In 2020, you will be able to contribute $19,500 to your 401k. If you are over age 50, then you are able to add an additional $6,500 per year. Keep in mind that the IRS can change these limits each year.
As you contribute money, you will not be able to pull it out until age 59.5. There are some exceptions, but you will need to jump through many hoops to withdraw any funds before the designated retirement age of 59.5.
What is an IRA?
The second type of retirement account that we will cover today is the IRA.
An IRA is also known as an individual retirement account. As the name suggests, this is not an employer-sponsored plan. With that, anyone will be able to contribute to an IRA if they want to.
With both of these accounts, you should be aware that there are rules surrounding your withdrawals. If you want to withdraw funds before age 59.5, then you might run into an additional 10% tax for the early withdrawal. But there are exceptions including withdrawing the funds for qualifying education expenses, first-time homebuyers, and more.
How much can you contribute?
Everyone is able to contribute to an IRA, but there are some limitations. You’ll have the option to contribute up to $6,000 to an IRA for 2020. But if you are over age 50, then you are able to contribute $7,000.
Types of IRAs
As you explore your options, you’ll uncover the fact that there are two common types of IRA -- Roth and Traditional. Here’s a closer look at both.
A traditional IRA offers the same tax-deferred benefits of a 401k. That means that the money you contribute to this retirement is with pre-tax dollars. The funds will not be taxed until you withdraw them in the future.
A Roth IRA offers a different kind of tax advantage. With this account, you would pay taxes on the dollars that you contribute to the account. However, you will not pay taxes on the withdrawals of your earnings or contributions in retirement.
If you want to contribute to a Roth IRA, then you’ll need to earn less than $124,000 for individuals or $196,000 as a married couple filing jointly.
What is the difference between a 401k and an IRA?
Now that you have a better understanding of these retirement accounts, it is time to dive into the differences.
Eligibility to contribute
The biggest difference is your eligibility to contribute. With a 401k, you would need to work for an employer that offers the retirement account in order to contribute. With an IRA, you don’t need the sponsorship of an employer to set this up.
Another major difference is the amount you are able to contribute each year. The contribution limits for a 401k are significantly higher than the limits for an IRA. That might factor into your retirement planning depending on your retirement timeline.
With a 401k, you will be limited to the investment options that your employer has chosen. In some cases, your employer may have picked less than ideal investment options.
In others, you might find that your investment goals align perfectly with the chosen picks. If you have a specific portfolio balance in mind, these limitations could be a problem.
With an IRA, you have the complete freedom to choose your investments. You won’t be limited by your employer’s choices. Instead, you can pick the investments that suit your retirement goals.
When you contribute to a 401k or traditional IRA, you will use pre-tax dollars. But when you withdraw the money, the funds will be subject to income taxes. Make sure to include that tax bill in your retirement plans. Otherwise, it can be an unpleasant surprise for your budget.
A Roth IRA requires that your contributions are made after-tax. When you move to take out your funds in retirement, you will not need to worry about paying taxes on any withdrawals.
Which should you contribute to?
Both of these retirement accounts have their advantages and drawbacks. However, both are useful tax-advantaged accounts that you can build a robust retirement portfolio withing.
If possible, it is a good idea to contribute to both of these accounts as you plan for retirement. But that is not always possible since you may not have access to a 401k.
If you do have access to a 401k with an employer match, then make sure to contribute at least enough to receive the full match.
For example, let’s say you are contributing $1,000, and your employer matches that. With the match, you’d have a total contribution of $2,000 instead of your original $1,000. Definitely a worthwhile use of your retirement savings!
Although you might not be able to completely max out your contribution limits for a 401k and IRA, it is important to consider both in your retirement plans. You can use the different tax advantages to craft a portfolio that works best for your retirement dreams.
The bottom line
401ks and IRA are both useful retirement accounts. However, the best combination of retirement accounts will depend on your unique situation and retirement goals.
Now that you have a better understanding of these accounts, consider their advantages as you map out your retirement savings plan. Keep learning about learning about retirement planning as you build the perfect plan for your money goals.
Take action today and work towards your retirement goals with the right account to help you along the way.