Making the right choice for your future is crucial. Consider many things, including your finances and relationships. One of your most important decisions is to invest your money. You may need to choose between a 401(k) and an individual retirement account (IRA). Both offer tax breaks, investment growth, and the ability to save for retirement.
What is a 401k?
An employer-sponsored retirement savings plan known as a 401(k) enables employees to set aside a portion of their pay for investments with the potential for high returns. The money saved is tax-deferred (meaning you only pay the contributions or the investment income once you withdraw it at retirement). Some companies also match an employee’s employees, which can add up to a nice chunk of change for your future.
Employees can also save for retirement using individual retirement arrangements (IRAs), including traditional pretax IRAs, Roth after-tax IRAs, and Simplified Employee Pension (SEP) IRAs set up by business owners for themselves and any employees. Unlike a 401(k), an IRA is not tied to your current employer, and you can open one with almost any brokerage firm or financial institution.
The only caveat is that you must qualify based on income and employment status to contribute to an IRA. Earned income includes wages, salaries, tips, bonuses, self-employment earnings, and annuities. Investment income, Social Security benefits, unemployment compensation, government pensions, and annuities don’t count; there are contribution limits for IRAs and 401(k) plans. If you have a 401(k) available at work, investing enough to get the full employer match before investing in an IRA is wise. It’s also worth comparing IRA options for fees, commissions, and minimum opening requirements.
What is an IRA?
An individual retirement account (IRA) is a tax-advantaged investment portfolio you set up independently. Unlike workplace plans, which employers offer, IRAs can be opened at any financial institution. You can manage your IRA yourself or work with a broker or robo-advisor to do it for you. These services can help you invest in various assets, including stocks, bonds, and exchange-traded funds.
The type of IRA you choose depends on your income and tax situation. Traditional IRAs allow you to deduct contributions from your taxes, whereas Roth IRAs allow you to contribute after tax and withdraw the funds tax-free in retirement. There are also SEP and SIMPLE IRAs for self-employed individuals and small businesses.
The most significant benefit of an IRA is that you can invest in many different asset classes, improving your chances of a healthy return on your investments. The key is to keep your eyes on the prize and stay invested even when the market stumbles. Research suggests that investors who visited during the Great Recession had much higher account balances ten years later.
What is the difference between the two?
Significant differences exist between 401k vs IRA. One of the most important differences is that a 401(k) is an employer-sponsored retirement plan offering employees tax benefits. In contrast, an IRA is an individual investment account established by the account owner without employer involvement.
With a 401(k), contributions are made from pretax dollars, and investments grow tax-deferred until withdrawn. The plan also typically offers a range of investments with different levels of risk. Lower-risk options offer safety and stability, while higher-risk options may provide more significant growth potential. Many 401(k) plans also include target-date funds, automatically adjusting your investment mix and risk as you retire.
An IRA is not tied to an employer, so anyone can open one and contribute to it, regardless of their job status or if the company offers a 401(k). An IRA allows for a broader range of investments, including stocks, mutual funds, exchange-traded funds (ETFs), and bonds. In addition, an IRA can be funded with money rolled over from a former employer’s other retirement accounts.
Consider doing so if you can max out a 401(k) and an IRA. This will maximize the money you have saved for retirement and give you more flexibility when it comes time to retire.
What is the best option for me?
While IRAs and 401(k)s offer tax incentives to save for retirement, the best option for you may vary depending on your situation. For instance, a traditional IRA is ideal for those who prefer an immediate tax break. In the year you make a pretax contribution, it lowers your taxable income; however, when you take withdrawals during retirement, you will be subject to taxes.
However, if you wish to defer paying taxes in the future, a Roth IRA is the best option. Even though you make after-tax contributions, you won’t be required to pay taxes on your investment gains when you take them out in retirement.
Another factor to consider is the investment options offered by each account. A 401(k) will likely have a more limited selection of investments than an IRA. However, many 401(k) plans offer advice or coaching services to help workers choose suitable investments.
Unlike a workplace plan, an IRA can be opened by anyone earning income. In addition, IRAs can be opened at most banks and brokerage firms. They also come in several types, including traditional IRAs and Roth IRAs.
IRAs are essential to any savings strategy, but keeping track of your contributions and ensuring you’re saving can be challenging.
