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It’s never too early to start thinking about your retirement options and how to save as much as you can for retirement. You have several choices for retirement savings, including a 401(k) and an individual retirement account (IRA).
These are the two most popular options because they both have tax benefits. However, they’re also quite easy to get confused. Let’s remove the confusion and explore the differences between 401(k)s versus IRAs and how they work.
What’s a 401(k) and How Does It Work?
A 401(k) is an employer-sponsored retirement account. Contributions can grow either tax-deferred or tax-free until you withdraw funds at retirement. The annual contribution limit for a 401(k) is $22,500 as of 2023 ($30,000 for those 50 years of age and older).
With a 401(k), a percentage of an employee’s salary is deducted from their paycheck and contributed to their 401(k), generally from the pre-tax salary amount. You can contribute any percentage you wish, but keep in mind that your employer may also offer a contribution match, usually between 3–6 percent.
If your employer offers a contribution match, it’s a good practice to maximize it. For example, if your employer matches up to 3 percent, make sure you’re contributing at least 3 percent of your paycheck to your 401(k).
Your own contributions to your 401(k) are 100 percent vested, which means they’re completely owned by you and aren’t forfeited if you leave the company. However, your employer’s contributions might be 100 percent vested at the start, or they could be vested after a certain amount of service with the company.
For example, if your employer’s contributions are vested after five years, that means if you leave the company after three years, your employer’s contributions to your 401(k) are forfeited. If your employer offers a 401(k), make sure you find out when their contributions are vested and what their contribution match is.
There are two primary types of 401(k) accounts. With a traditional 401(k), contributions are taken out of your paycheck pre-tax, so you won’t pay taxes on your contributions. The funds aren’t taxed until you withdraw money for retirement.
With a Roth 401(k), contributions are taken out of your paycheck after taxes, which means you’ve already paid taxes on your contributions. However, the money will continue growing tax-free and then you can withdraw it in retirement without paying taxes.
Benefits of a 401(k)
There are several benefits to a 401(k), including:
- High contribution limits.
- Company matches on your contributions.
- Automatic deductions from your paycheck.
- Security against creditors.
Disadvantages of a 401(k)
Some disadvantages of 401(k) accounts include:
- Not all employers offer one.
- There’s a limited selection of investments.
- A potential inability to choose between a traditional 401(k) and Roth 401(k).
What’s an IRA and How Does It Work?
IRAs enable anyone who’s earning income to grow their money either tax-free or tax-deferred until it’s withdrawn in retirement. There’s an annual contribution limit to IRAs ($6,500 as of 2023) but it generally increases every few years. Individuals over 50 years of age can contribute $1,000 more than the annual limit per year.
There are several types of IRAs, each with its own benefits and rules. But the most popular types are traditional IRAs and Roth IRAs.
A traditional IRA is the most popular type of account because of the tax benefits. Pre-tax dollars can be contributed from your paycheck to the account, and the funds continue to grow until you make withdrawals.
Roth IRAs enable you to contribute money after tax from your paycheck to your IRA account. Your funds will continue to grow without being taxed and can be withdrawn tax-free.
Benefits of IRAs
There are several benefits of IRAs, including:
- Anyone with earned income can contribute to an IRA.
- They’re easy to set up.
- They’re easy to withdraw funds from.
Disadvantages of IRAs
Some disadvantages of IRAs include:
- Low contribution limits.
- Income limits.
- Investment advice isn’t offered.
How to Choose: 401(k) vs. IRA
Trying to decide between a 401(k) versus an IRA? If your employer offers a 401(k) with a company match, it’s a good idea to take advantage of it. If your employer doesn’t match contributions, you may want to consider starting with an IRA because you’ll have more choices of investments. After meeting your IRA contribution limit, you may consider contributing to a 401(k) as well to take advantage of the pre-tax benefit.
Make Sure You’re Prepared for Retirement
Making sure you’re prepared for life events is important—especially when it comes to retirement. 7 17 Credit Union has several resources to help members prepare for retirement, marriage, and many other events. Contact us to learn more.
