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If you're thinking about starting to save for retirement, chances are good that you are looking at both Roth IRA and 401(k) plans. Both offer tax benefits and can help you grow your wealth over time, but there are several key differences between the two. The biggest one? When you want to pay taxes — now or later. If you have access to an employer-sponsored 401(k) account, you pay taxes when you withdraw your earnings in retirement at whatever rate your tax bracket is at the time. The account is funded with pre-tax dollars diverted from your paycheck by your employer, which lowers your taxable income each year that you contribute. Roth IRAs, on the other hand, are funded with post-tax dollars, so the money grows tax-free. You can also withdraw your contributions at any time (but not your earnings) with no tax penalty, unlike 401(k)s which typically hit you with a 10% penalty if you access any of the money early. Many employers offer to match a certain percentage of employee 401(k) contributions, effectively doubling a portion of your investment each pay period for free. If your employer offers a contribution match, don't leave any money on the table. "We always encourage people to contribute enough to get the maximum employer contribution," says Sarah Hampton, co-founder and partner at wealth management firm 6 Meridian. The maximum amount workers under 50 can put in their 401(k) in 2021 is $19,500. Those 50 and older can also put in an additional $6,500 in catch-up contributions. With Roth IRAs, investors younger than 50 are limited to contributing $6,000 in 2021, and those 50 and older can contribute an additional $1,000. "Contribute early and often, because you can't catch up later," Hampton says of 401(k) plans. "Once the calendar year is gone, you can't go back." When it comes to the control you have over your money, 401(k)s limit you to pre-screened funds that have been approved by your employer's plan, whereas a Roth IRA gives you a wider range of options including stocks, bonds, ETFs and index funds. However, if you can afford it, Hampton recommends contributing to both a 401(k) and a Roth IRA. "You get a more tax-favorable outcome this way," she says. "Your Roth IRA and 401(k) can continue to compound their growth on each other, as opposed to having to pay tax as you go." No matter what you choose, the earlier you decide to start investing, the better you set yourself up for retirement. Sign up now: Get smarter about your money and career with our weekly newsletter Don't miss: Nearly 70% of millionaires are worried about leaving 'too much' money to their kids, survey finds Americans have several choices when it comes to saving for retirement. Two of the most popular options are a 401(k) plan and an individual retirement account (IRA). Assets in 401(k) plans totaled $7.7 trillion as of year-end 2021, according to the Investment Company Institute (ICI). Meanwhile, IRAs had a massive $13.9 trillion balance in the same period, says ICI. Many people get the two plans confused, and it’s understandable given the similarities. Both offer the potential for tax-deferred investment growth (or tax-free growth if you opt for the Roth versions of either plan), tax breaks on contributions and the ability to invest in assets such as stocks and mutual funds that have a higher potential return than savings accounts and bonds. Below are the key ways in which a 401(k) and an IRA differ. We’ll also discuss which one may be a better fit for your personal retirement situation. What is an IRA?An IRA is an individual retirement account that allows anyone with earned income (and even their spouse) to save for retirement on a tax-advantaged basis. Inside an IRA your money can grow tax-free or tax-deferred until you take it out at retirement. This special tax advantage allows your money to compound at a higher rate, letting you accumulate more over time. The annual contribution limit to an IRA is $6,000 in 2022, though this figure usually rises every few years. Those over age 50 can contribute an additional $1,000 each year. You can open an IRA at many different financial institutions, including banks and brokers, and you can buy several kinds of assets inside your IRA, including CDs, stocks, bonds, mutual funds, ETFs and more. The best IRA accounts let you invest in potentially high-return assets such as stocks and stock funds. Types of IRAsThere are two major types of IRAs, and they differ in the tax advantages they offer you:
Those are some of the largest differences between the two major types of IRA, but you’ll want to understand some of the other finer points of each IRA before deciding which is right for you. What are the pros and cons of an IRA?The IRA offers a similar variety of pros and cons. Here are the most important: Pros of an IRA
Cons of an IRA
What is a 401(k)?A 401(k) plan is an employer-sponsored retirement plan that allows a company’s workers to save for retirement on a tax-advantaged basis. In a 401(k), money can grow tax-deferred or tax-free until withdrawn at retirement. Employees can deduct a portion of their salary from their paycheck and have it invested in potentially high-returning assets such as stock mutual funds. The annual contribution limit to a 401(k) is $20,500 in 2022, and this figure usually rises every few years. Those aged 50 and over can make a $6,500 catch-up contribution each year. You may only open a 401(k) plan if your employer offers one. The plan will provide a fixed set of investments, often mutual funds, that you may invest in. These funds typically invest in stocks, bonds or a combination of the two such as in target-date funds. Many 401(k) plans also “match” a portion of the employee’s contributions to the account, providing “free money.” An extra three to five percent of salary (sometimes more) is possible. Types of 401(k) plansThere are two major kinds of employer-sponsored 401(k) plans, and the key difference is the kind of tax advantage they offer:
Those are the largest differences between the two kinds of 401(k) plans, but one employer’s plan may differ in important ways from another’s, so it’s important that you read the fine print on your plan to see what it allows and does not allow. Employee contributions to a 401(k)Employee contributions to a 401(k) plan are limited to $20,500 in 2022. Employees can have the money seamlessly deducted from their paychecks and deposited into their accounts, making it easy for employees to participate in the plan and not feel as if they’re missing the money. If they’ve opted to purchase mutual funds as part of their plan, the money will be automatically invested in those funds, according to the investment plan. Employer matching contributions to a 401(k)Many employers provide a matching contribution for some or all of an employee’s 401(k) contribution, incentivizing employees to participate in the plan. Matching contributions are considered to be traditional 401(k) deposits, even if the employee contributes to a Roth 401(k). For example, some employers may match 50 percent of an employee’s contributions up to 8 percent of their salary each year. If the employee contributed 8 percent, the employer would add another 4 percent, and the employee would effectively enjoy a total of 12 percent saved. But if the employee contributed 10 percent, the employer would still add a maximum of 4 percent. Employers offer different matching amounts, and some employers may offer no match at all. Many employers require matching contributions to vest over time. For example, if the employer requires three years of vesting, employees must remain with the company for at least three years before any matching funds become fully theirs. However, once the employee has surpassed the vesting period, any subsequent matching funds immediately become theirs. Matching funds may partially vest, depending on the employee’s length of service. For example, with a three-year vesting schedule, an employee who stays two full years may be able to keep two-thirds of any matching funds. But the rules depend on the details in the employer’s plan. What are the pros and cons of a 401(k)?To sum up, the 401(k) plan offers a variety of pros and cons. Here are the most important: Pros of a 401(k)
Cons of a 401(k)
Is it better to have a 401(k) or an IRA?With so many similarities, which one should investors choose? Well, if you can max out your contributions to both, then you won’t have to choose — while enjoying the full advantages each has to offer. But even though it’s permitted, many people can’t afford to do so. Forced to choose, many experts believe the 401(k) is the clearly superior option. “There is actually no comparing IRAs and 401(k)s,” says Joseph Auday, a wealth advisor with Steel Peak Wealth Management in Beverly Hills, California, citing the 401(k)’s higher contribution limit and the potential for an employer match. “If you’re not taking advantage of your 401(k), you’re missing out.” However, advisors also stress that both plans remain valuable to retirement planning. “IRAs and 401(k)s can both provide unique value to an individual’s retirement strategy, with key uses and specific pros and cons worthy of consideration,” says Michael Burke, CFP at Lido Advisors in Southbury, Connecticut. Other key differences between the 401(k) and an IRABut it’s worth pointing out some key differences between the two so that you can prioritize the one that works better for you:
Bottom line“The best retirement plan for an individual will often include both a 401(k) as well as an IRA,” says Burke. “By understanding the differences between the two, an individual can make better-informed decisions, and ensure they are getting the most value out of their investment choices.” |