When it comes to preparing for the future, making the commitment to regularly set money aside in savings is the first hurdle. Maybe this explains why half of all American households don’t have any retirement savings at all, let alone know the differences between an IRA vs a 401(k).
Once you realize that your 20 or 30 years of retirement won’t pay for themselves, selecting the best retirement savings account and what types of stocks, mutual funds, and ETFs to invest your money in, is your next hurdle. You’ve probably heard terms like 401(k), employee match, and Roth IRA being thrown around, but what do they actually mean for your future?
Let’s break down the differences between the two most popular types of retirement savings accounts so that you can start working toward that $1 million mark.
What Is an IRA?
Overall, an Individual Retirement Account (IRA) is a savings account that allows you to save for retirement using special tax benefits. There are two main types of IRA accounts, the traditional IRA and the Roth IRA. Each offers its own tax advantages, so let’s take a look at both of them.
If you choose to squirrel away your money in a traditional IRA, your money will grow on a tax-deferred basis. Other specific benefits and requirements include:
- You can contribute up to $6,000 per year (or $7,000 if you’re 50 or older) in an IRA (in 2022)
- You don’t owe taxes on traditional IRA funds until you withdraw the funds
- All IRA contributions are tax-deductible up to the IRS limits
- You must wait to withdraw money from an IRA until 59½ or older to avoid penalties
- You must start withdrawing money by age 72
Overall, an IRA gives you the opportunity to grow and compound your retirement investment faster than it would in a taxable account. This type of account is easy to open at nearly any bank, brokerage company, or investment firm.
A Roth IRA is very similar to the traditional IRA described above. They both use the same contribution limits and deadlines.
There’s just one main difference: a Roth IRA is a tax-free account. Although your contributions can’t be deducted on your annual tax return, your money grows tax-free and can be withdrawn without owing any taxes on your IRA distributions. It’s truly one of the most important financial accounts anyone can have!
Here are a few other important details to know about Roth IRA investments:
- Your income affects the amount you can contribute (in 2022, a single individual making less than $129,000 can contribute up to $6,000 a year)
- No required minimum distributions during your lifetime
Other IRA options are available through banks, investment firms, and brokerage companies, including the SIMPLE IRA through employers, spousal IRA, and self-directed IRAs.
What Is a 401(k)?
A 401(k) is a retirement savings plan sponsored by employers, which means it’s only available through the workplace. When you enroll in a 401(k), you can save and invest a chunk of each paycheck before taxes are deducted. For example, if your gross income is $2,000 bi-weekly, you can direct $500 into a 401(k) and only pay taxes on the remaining $1,500. In many ways, this is a smart tax play: you get taxed less each year by deferring the taxes on your 401(k) contributions until retirement (when you’ll probably be earning less money). This move can even push you into a lower tax bracket now, which can save you lots of money!
Oftentimes, your employer chooses how to invest the money, usually from a range of mutual funds the plan offers. Other times, you may be able to select the funds you’d like to invest in and adjust along the way based on the fund’s financial performance. Many employers even offer to match a portion of every 401(k) contribution you make! This is an excellent perk that gives you free money and a huge savings incentive.
Here are the most important points you need to know before opening a 401k with your employer:
- Individuals can contribute up to $20,500 a year (with the option to add an additional $6,500 catch-up contribution each year if age 50 or older) in 2022
- You can contribute to a 401(k) and an IRA/Roth IRA at the same time
- Some employers match 100% of employee contributions, while some offer a 50% or 25% match on each 1% contribution you make. Meanwhile, others only offer their percentage match up to a certain portion of your total income.
Keep in mind that 401(k) accounts do have their rules and regulations, such as paying taxes on everything you withdraw in retirement. It’s also important to stay updated on the latest financial news and laws when it comes to retirement, like the passage of the Secure Act 2.0 in Congress, which oftentimes impacts your retirement savings.
Why Do Employers Match 401(k) Contributions?
There are actually a few reasons why 401(k) matching is attractive to businesses.
First, matching employee 401(k) contributions helps employers secure tax breaks. All matched contributions are deductible on federal corporate income tax returns, up to 2% of all participants’ compensation.
Then, there’s competitiveness. Companies want to attract and retain excellent employees, and it’s much easier to land top talent with perks like matches. Listing “401(k) employer match” in a job description carries a lot of power.
Peer pressure also plays a part in the growing generosity of company matches. As the economy improved after the Great Recession of 2009-10, a few progressives led the way and forced other employers to keep pace. For the first time in 20 years, the most common 401(k) match plan is structured to match employee contributions dollar-for-dollar up to the first 6% of income.
IRA vs 401(k): Choosing the Best Option
There’s good news! You don’t have to choose if you don’t want to. As long as you meet the income requirements set for IRA accounts, there’s nothing stopping you from contributing to a 401(k) and an IRA. In fact, many savvy savers utilize both to bulk up their retirement funds.
Since a 401(k) plan allows you to contribute up to $20,500 a year (with the option to add an additional $6,500 annual catch-up contribution each year if age 50 or older) in 2022, experts recommend using your 401(k) up until its limit to maximize your employer contribution. After all, that’s free money toward your retirement.
Once your 401(k) hits its limit, direct your retirement savings into an IRA instead. Evaluate your best option between a traditional or Roth IRA based on your tax priorities. If it’s more important to reduce your taxable income now, then choose a traditional IRA and deal with those taxes in retirement. If you’d rather enjoy tax-free distributions later in life, select a Roth IRA.
Overall, neither type of account is better or worse than the other. They both offer important benefits and unique features that can help you save for the future. It’s important to closely evaluate the quality of each investment choice with a professional to make the best decision for your wallet.
Read More: How Much Should I Save For Retirement?