Should you open an IRA or a 401(k)? We break it down.
Like most people, you’re probably planning to retire. And you’ll want to get the most out of the years when you no longer have to work, hopefully filling it with travel, time with your family, and pursuing hobbies you may not have had time for while you were working.
But you’ll need to make sure you have enough savings to retire.
With that in mind, you’ll want to know about the retirement accounts available to you, as well as the differences between two key accounts, the Individual Retirement Account (IRA) and a 401(k).
IRAs and 401(k)s are retirement accounts.
IRAs and 401Ks are both tax-advantaged retirement accounts that could help you save for retirement.
While you can have both types of accounts simultaneously, there are annual limits to how much you can put away. To decide which may be a better fit for you, you’ll need to dig into the details.
IRA vs. 401(k): What’s the Difference?
IRAs and 401(k)s are two common vehicles that individual investors can use to start saving for retirement.
A 401(k) is usually provided through an employer and can have an employer-match benefit, whereas anyone can open an IRA by opening an account at a bank or some other financial institution that offers it.
The IRA versus 401(k) question is important to address since both accounts have the same goal: helping you save for retirement. However, the amount you have saved by the time you reach retirement age can vary quite a bit depending on your income and how much you save.
A 401(k) is a qualified employer-provided retirement plan, meaning it satisfies federal tax guidelines for such plans. Often, an employer will provide this plan to employees with an additional perk, called a matching contribution. This means that employers match the funds you place into your account, generally up to a certain percentage, potentially allowing you to save more, faster.
You typically contribute funds to a 401(k) from pre-tax income, which can lower your taxable income. However, this does not mean you won’t pay taxes. You must pay taxes when you start withdrawing money from the account, typically after age 70 ½.
Workers under 50 can deposit up to $18,500 in pre-taxed income into a 401(k) per year. (Over 50, you can make additional contributions of $6,000.) Contributions above those limit are subject to income tax.
An IRA is an individual retirement account that anyone can open up through a brokerage or financial institution.
Similar to a 401(k), contributions to an IRA are made on a pre-tax basis, and they can lower your taxable income. You must also pay taxes when you start withdrawing money from the account, typically after age 70 ½.
Both 401(k) and IRA accounts can allow you to save for retirement by investing in products such as CDs, stocks, bonds, and other securities.
Types of IRAs Roth, Traditional, Etc.
Traditional IRAs and a Roth IRAs are the two most common types of retirement accounts, but there are others. These include Simple IRAs, for small business owners, and the SEP IRA, for sole proprietors. Here’s a look at each account type.
Traditional IRA accounts provide some tax advantages, as your contributions are made from your income on a pre-tax basis. Account owners pay taxes on the funds when they withdraw them.
For example, if you contribute $3,000 to your IRA in a given year, that will lower your taxable income by an equivalent amount for that tax year, and can potentially lower your tax bill. People under age 50 can contribute up to $5,500 annually to an IRA. For investors who are 50 years old and older, you can contribute up to $6,500.
The same annual contribution amount applies to a Roth IRA as a traditional IRA, but you contribute to a Roth with income after taxes have been deducted. In contrast to a traditional IRA whose withdrawals are taxed, Roth investors generally don’t pay taxes on withdrawals once they’ve reached retirement age.
A Savings Incentive Match Plan for Employees, or Simple IRA, is designed specifically for small business owners and their employees. These accounts allow employees to make contributions to retirement accounts, which employers are required to match, generally up to 3% of their total contribution.
The funds in this IRA can reduce your taxable income, similar to a traditional IRA. The money is taxed upon withdrawal in retirement.
SEP IRAs, or Simplified Employee Pension plans, are designed for the self-employed, such as small business owners who are sole proprietors, freelancers, and contractors. They allow for much bigger contributions than either a 401(k) or IRA, up to $54,000. Small business owners with employees who create a SEP, must generally also make contributions for their employees in any year they make them for themselves.
Can You Have a 401(k) and an IRA?
When deciding between an IRA versus 401(k), it is important to remember that an employer sponsors a 401(k). Anyone can open an IRA.
And while it’s possible to have both types of accounts, you may not be eligible for the full tax advantages of both in a given year.
Annual contribution limits also apply. Generally speaking, you can contribute up to $18,500 in a 401(k) annually, and $5,500 to a traditional or Roth IRA. After age 50, you can contribute an additional $6,000 to a 401(k) annually, and an additional $1,000 to an IRA.
Comparing The Two: IRAs & 401(k)s
While a 401(k) is tied to an employer, anyone can open an IRA. However, both IRAs and a 401(k)s have the same goal: Helping you save money for retirement.
Both the IRA and 401(k) can be either traditional or Roth accounts. The one you choose depends on our tax situation. Generally, if you are in a higher income bracket, you might consider a traditional account, as it could lower your taxable income. If you have a lower income, then a Roth account might make more sense, as you’ll be able to make tax-free withdrawals after retirement.
Making the Right Decision
When deciding between an IRA and a 401(k), some people might wonder if one produces a bigger return than another.
It’s important to remember that both accounts generally will let you invest your money in a variety of stocks, bonds, mutual funds, exchange-traded funds, and other securities. Your investment strategy will determine returns for both types of accounts, in addition to market performance, which can fluctuate. Bear in mind, any fees charged to your account for things like trading, monthly maintenance, or management will also affect your total return.
One important advantage of a 401(k) is that it lets you put more money away annually, and it may also include an employer match. When an employer matches a percentage of your contributions, you’re essentially getting free additional money from them, which can increase your savings in the account over time.
In recent years, young workers have increasingly opened retirement accounts. In fact, 401(k) balances have doubled between 2008 and 2017, according to the Investment Company Institute.
It’s important to remember that the sooner you start funding a retirement account such as an IRA or 401(k), the more money you can potentially save by taking advantage of something called compounding, which is when the returns and interest your accounts earn also earn additional interest and returns.
Employer Benefits and Other Factors
Employers can sometimes provide a company match to your 401(k) contributions, typically between 3% to 6% of your own annual contributions.
While an employer match is often called “free money,” your ownership of the matching money will typically “vest.”
That means an employee owns the money according to a schedule–typically over a period of years–that’s intended as an incentive to stay with a company.
For example, you may vest in your matching money at a rate of 25% per year. That means after four years, all of the employer matching money belongs to you. If you leave before the vesting period ends, your own contributions are 100% yours to keep, but you could lose a portion of the matching money.