When it comes to saving for retirement, Americans have a few different options. Two of the most popular options are a 401(k) plan and an individual retirement account (IRA). Many people get the two programs confused, and it’s understandable given the similarities.
Below are the key ways in which a 401(k) and an IRA differ.
What is a 401(k)?
A 401(k) plan is an employer-sponsored retirement plan that allows employees to save for retirement while minimizing their tax liability. Employees can invest a portion of their compensation in potentially high-returning assets such as stock mutual funds by deducting a percentage of their salary from their paycheck. Money can grow tax-deferred or tax-free in a 401(k) until it is withdrawn at retirement.
The main distinction between the two types of employer-sponsored 401(k) plans is the type of tax benefit they provide:
- Traditional 401(k)s let employees save for retirement on a pre-tax basis, meaning you won’t pay taxes on any contributions. The money in the account can grow tax-free until it is taken at retirement. Any money removed during retirement is taxed at standard income rates. It would be best if you took the needed minimum distributions each year after 72. Notably, a regular 401(k) is always tax-deductible, regardless of your income.
- The Roth 401(k) allows employees to save for retirement with after-tax dollars, which means any contributions will be taxed. The money in the account, on the other hand, can grow tax-free and then be withdrawn tax-free when you reach retirement age, which is defined as age 59 or later. You will be compeled to take needed minimum distributions beyond 72. However, a Roth 401(k) can be rolled into a Roth IRA with little or no tax penalties.
What is an IRA?
An Individual Retirement Account (IRA) is another way to save and invest for retirement, but it’s something you may do rather than via your company. You can start a self-directed IRA with a bank, credit union, investment business, broker, or mutual fund provider. There are two major types of IRAs:
- Traditional IRAs allow you to save for retirement on a tax-deferred basis, so you won’t have to pay taxes on any contributions you make. The money in the account can grow tax-deferred until you withdraw it in retirement. You’ll be subject to standard income tax rates when you take the cash out. Your income determines a typical IRA’s tax-deductibility and whether or not your company offers a retirement plan. You’ll be obligated to take the minimum distributions each year after 72.
- The Roth IRA lets you save for retirement with after-tax dollars so that you won’t get a tax break on your contributions. You will, however, be able to grow your money tax-free and then withdraw it tax-free if you reach the age of 59, 12 or later. You won’t be obliged to take minimal withdrawals, and you’ll be able to pass the money on to your heirs tax-free, unlike with a traditional IRA. The Roth IRA has income limits, so you may not be allowed to participate if you make too much money.
Which is better? An IRA or 401(k)?
401(k)s and Individual Retirement Funds (IRAs) are beneficial retirement accounts. However, your specific situation and retirement objectives will determine the ideal retirement account mix.
Starting your retirement planning early could make the difference between leading a comfortable life and struggling financially once you retire. Don’t know how to start planning? Reach out to Briteside Solutions today!