Are you saving for retirement? Are you having a difficult time sorting out the difference between a 401k vs IRA?
These are the two most common types of retirement plans. While they may seem overwhelming at first, they’re actually fairly simple to set up and can provide some good tax advantages.
Understanding the difference between a 401k and an IRA will help you ensure you have enough money to live on in your retirement. Keep reading to learn more about what they are and which one is best for you.
What Is a 401k?
A 401k is an employer-based retirement savings plan. It offers a choice of investment options, usually a mutual fund or exchange-traded fund (ETF).
You contribute a portion of your pretax income to the account. This is automatically deducted from your paycheck, similar to taxes and Social Security.
Many employers will match your contribution up to a specified amount. This is a great incentive and one of the biggest reasons to participate. It’s common for employers to match between 3-6% of your annual earnings.
However, to receive all the company contributions you may need to become vested. That is, you need to stay in your job for a specified amount of time or risk losing a portion of the company contributions. Every company has its own rules for how long you must stay at the job to become vested.
Most financial advisors recommend saving at least enough to get the full company match. This is effectively a guaranteed return on your money.
What Is an IRA?
Another option for retirement savings is to invest in an IRA. You can opt for a Traditional or Roth IRA depending on what fits your needs better.
IRA stands for Individual Retirement Account. It is a savings option you can do yourself; you do not need to go through your employer. Most financial institutions such as banks, credit unions, and investment firms offer them.
With a Traditional IRA, you make your contribution before paying taxes, which can reduce your taxable income. Instead, your contributions are taxed after you withdraw your funds.
A Roth IRA however uses after-tax contributions. That is, you pay the taxes upfront and your earnings grow tax-free. Because you have already paid taxes on your money, it is not subject to income tax when you withdraw it.
If you need a tax break right away or think your tax rate will be lower in retirement, you should consider a traditional IRA. If you have reason to believe your tax rate will be higher in retirement, then consider a Roth IRA.
If you or your spouse has a 401k option through work, your IRA options may be reduced or limited. Also, while a traditional IRA does not have any income limits, there are limits for a Roth IRA.
Participating in a 401k doesn’t affect your eligibility to participate in a Roth IRA. Just keep aware of the yearly income limits. The IRS is a good source of information for contributions and income limits.
What is the Difference Between a 401k and an IRA?
There are some similarities and differences between these retirement plans. They both let you save for retirement and offer tax benefits.
The most obvious difference between them is that a 401k is an employer-based plan and an IRA is an individual plan. But there are some additional differences to consider.
With traditional IRA and 401k plans, you can begin taking deductions at age 59 ½. There are penalties for taking money out sooner. And, with both plans, you are actually required to start taking minimum distributions at age 72.
However, a Roth IRA has no requirement to take minimum distributions. And if you’ve had your Roth IRA for at least 5 years you can withdraw money at any point without penalties.
An IRA includes only your contributions and earnings. A 401k will include both of those and likely a matching contribution from your employer.
There is no tax on your earnings over the years in either program. With a traditional IRA and 401k plan, your monies are taxed when you withdraw them in retirement. Roth IRA distributions are not taxed because the contributions were from post-tax money.
You can contribute more money to a 401k plan. In 2020, you may contribute up to $19,500 to a 401k plan ($26,000 if you’re age 50 or older). This does not include any amounts your employer may add. However, with either IRA option, you may only contribute $6,000 ($7,000 if you’re 50 or older).
Traditional and Roth IRAs provide a wide range of investment options. Your choices may include individual stocks and bonds, mutual funds, ETFs, real estate, and certificates of deposit.
A 401k plan often has more limited investment options, depending on the plan your employer chooses. Most plans include only mutual funds and ETFs.
It is sometimes possible to take out a loan or hardship withdrawal from a 401k option. Generally, loans are not possible with an IRA. There are a few options to take money out of an IRA if it is returned within 60 days.
With a 401k, it is a federal law that your spouse (if you have one) is your beneficiary. If you want to name someone else, your spouse must consent to it in writing.
With an IRA you are able to designate anyone you wish as your beneficiary. You do not need a spouse’s consent if you wish to designate someone else.
Saving Your Way to Retirement
You can make the most of your retirement savings once you understand the difference between a 401k and an IRA. Take advantage of any employer match if you have it. Then, use the option that provides the best tax benefit to you.
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