Saving for retirement is critical to financial fitness, and luckily, there are plenty of options available.
Two of the most popular, however, are Individual Retirement Accounts (IRA) and 401(k) plans. These plans are designed to help individuals save money for retirement through investments such as stocks, bonds, mutual funds, index funds and more.
While the two types of accounts are similar in structure, there are some key differences – and pros and cons – that you should note to help you make the right decision when it comes time to invest.
Read below for some key information you need regarding IRAs and 401(k) plans.
IRAs Defined
IRAs are accounts held by a financial institution that an individual can use to save money for retirement by investing in things like stocks, bonds, and real estate property. These tax-deferred accounts come in different varieties such as: Traditional IRA, Roth IRA, Rollover IRA, and more.
Traditional IRAs allow you to make pre-tax contributions up to the annual limit determined by the Internal Revenue Service (IRS). The contributions made into the account may be fully or partially deductible on a tax return, depending on factors such as annual income and filing status. With this account, the owner won’t pay income taxes until the funds are withdrawn.
Similar in structure, a Roth IRA offers tax benefits for account owners. Because investments are taxed up-front, the account grows tax-free until the owner is ready to withdraw them in retirement.
Accounts like a Rollover IRA can be used to transfer money from one employer-sponsored retirement plan, such as a 401(k) into an IRA. In many cases, this is a tax-deferred way to transfer money without early withdrawal or penalty fees.
Because many IRAs and 401(k) plans have similar structures, there are some pros and cons for each that you should note to help you make the right financial decision.
IRA Pros
- Accessible and Easy to Set Up: Because IRAs are individually owned, participants can simply enroll online rather than working with an employer to create and maintain an account.
- Tax-Free Growth: Once money is contributed to an IRA, there are no taxes required for capital gains and dividends until distribution.
- Tax Deductions: Roth IRA contributions are made with after-tax dollars, meaning that the taxes can be deducted from your income at the time of deposit rather than at distribution. Traditional IRAs allow pre-tax contributions, meaning that the money is taxed upon withdrawal instead of deposit.
- Various Investment Options: IRAs allow the participant to choose from a wide range of investment options, including stocks, bonds, real estate, and more.
IRA Cons
- Contribution Limits: The IRS determines a contribution limit every year and is typically lower than 401(k)s or other employer-sponsored programs. View the current contribution limits here.
- Early Withdrawal Penalties: If you withdraw your funds before the retirement age of 59½, you will likely face a 10% fee plus tax.
- Required Withdrawal Schedule: When you reach the age of 72, you will be required to withdraw the minimum distribution from your account each year. There are penalties if you fail to follow the schedule and can be up to 50% plus tax.
401(k) Plans Defined
A 401(k) plan is an employer-sponsored retirement savings account. With tax-deferral benefits, employees can elect to participate in a plan via payroll deductions for savings contributions.
Many employers also offer 401(k) matching to employees that participate in the plan, which can help participants save even more money. Learn about employer-match programs on the Slavic401k blog here.
When a participant is ready to withdraw funds, the funds are taxed at the participant’s income rate and there is no penalty for withdrawals made after the age of 59½ and older.
401(k) Pros
- Tax Benefits: Contributions are tax-deductible, and in some cases, participants have the option to choose whether they’d like to pay their taxes up-front or when it’s time to withdraw. This flexibility can help participants financially plan and save for retirement without aggressive restrictions. Some plans vary in structure though, so speak with a financial advisor to understand your plan terms before taking action.
- Employer-Match Programs: Some employers offer 401(k) match programs to help employees save for retirement. Simply put, employers will match up to a certain percentage for 401(k) contributions, essentially giving the employee free money. There are some vesting schedules that many employers implement though, so talk to your company’s Human Resources team to understand the match and vesting structure.
- Higher Contribution Limits: In many cases, employer-sponsored plans allow you to add more into your retirement savings than an IRA. Discuss your plan options with your employer to better understand the limits.
401(k) Cons
- Limited Investment Options: Because 401(k) plans are managed by an employer, the options for investments are reduced. You may only have a few options to choose from, including index funds, company stocks, etc.
- Fees for Early Withdrawals: 401(k) funds are not easy to access once they’ve been contributed. In many cases, if you make a withdrawal before the retirement age of 59½, you will face significant penalties plus taxes.
- Employer Limitations: Not every employer offers a 401(k) plan. When interviewing for a new job, ask about the company’s benefits to better understand which retirement options – if any – that are available to you.
While there are many account options, some may be better for you than others. When opening an account, make sure you speak with a financial advisor to determine which type works best for your finances and your goals. You can also use a retirement calculator to help you along the way – like our Roth vs. Traditional 401(k) calculator.
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