Learn More About 401(k), IRA and Other Retirement Savings Options
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Retirement saving options are a crucial part of financial planning, and there are many ways to help you reach your goals. Two popular options for retirement savings are the 401(k) and the Individual Retirement Account (IRA). Both offer unique benefits and understanding them helps you make better decisions about your retirement savings strategy.
What is a 401(k)?
A 401(k) is a retirement savings plan sponsored by employers. The name comes from the section of the tax code governing these plans. The key benefit of a 401(k) is its special tax treatment, which allows participants to defer taxes on the growth of the funds within the account. This contrasts with a typical savings or investment account where taxes might be owed every year. A 401(k) plan provides savers with an opportunity to invest their money, potentially leading to compounding growth.
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What is an IRA?
An IRA is a tax-advantaged retirement savings account for individuals. Unlike a 401(k), an IRA can be set up by an individual rather than relying on an employer. These accounts allow people with earned income to save for long-term goals, such as retirement, in a tax-advantaged way. Like a 401(k), taxes generated within the account are deferred or postponed until the funds are distributed.
What’s the difference between traditional vs. Roth?
Most 401(k) plans and IRAs now offer the option to save in a traditional or Roth bucket. The saving method is the same, but the tax treatment differs. In a traditional bucket, savers can deduct their contribution from their taxes in the year they contribute, provided all qualifications are met. Taxes won’t be owed on these funds until they are distributed in a later year. At that point, the contribution and any growth will be subject to tax.
Alternatively, savers can utilize the Roth bucket. This strategy involves paying tax on the funds before they are contributed into the account. When the funds are withdrawn in later years, the contribution and growth will not be subject to taxation since it was paid upfront. Again, provided that all qualifications are met.
What is required for eligibility?
Eligibility for a 401(k) depends on the employer’s plan document. Typically, an individual must be employed by the company for at least one year and be at least 21 years old.
Anyone with earned income, such as from a W-2 or 1099 job, may be eligible for an IRA. However, if your household income is above a certain threshold, you may be limited in how much you can deduct on the contribution to your traditional IRA or how much you can contribute to your Roth IRA. These limits change every year. Consider consulting with your tax professional or the IRS for more information.
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What are the benefits and drawbacks of a 401(k)?
One of the best benefits of saving in a 401(k) is the ease of participation. The company sets up the account and individuals simply participate. For most plans, an employee must take action to begin participating. Some plans make it even easier by automatically enrolling employees but leaving them an option to opt out.
A 401(k) also typically allows for high contribution limits. In 2024, a saver can contribute up to $23,000 into a traditional or Roth 401(k). They may have an option to save even more if they are 50 or older.
Most companies also provide some sort of matching contribution to encourage saving. This benefit allows the employer to match your contribution, typically dollar for dollar, up to a certain percent of your salary, for example, up to 3% of your income as long as you contribute at least 3%. Some plans may even allow the employer to share a portion of the profit into the 401(k) in good years.
However, 401(k) accounts may not have the flexibility for investment options that IRAs have. Sometimes, these options have higher-than-average fees that can eat away at your retirement funds. 401(k) accounts also typically have a vesting schedule for the contributions from the employer. This means individuals may have to work for the same company for several years before the employer contributions truly belong to them. High earners may be subject to additional rules limiting how much they can contribute to their 401(k).
What are the benefits and drawbacks of an IRA?
The top benefits of saving in an IRA are flexibility and control. Unlike a 401(k), you have much more freedom to choose your investments. You might even decide to have a professional manage the IRA for you to ensure it’s being invested in a way best supporting your goals. There is also a special rule allowing savers to open a spousal IRA for a spouse who doesn’t have a job. This is a big benefit over 401(k) options.
The biggest drawback of an IRA is a relatively small annual contribution limit. In 2024 it’s only $7,000 unless you qualify for catch-up contributions. You are also limited to the amount you earn. So, if you only earn $5,000 in 2024, you will be capped at that amount rather than the full $7,000. There are also strict limits to how much of the contribution you can deduct off your taxes for the traditional IRA. Roth IRA contributions are limited by how much you earn annually.
Should a person consider both retirement savings options?
Investing in both a 401(k) and an IRA allows you to save money for the long-term goal of retirement, although they have slightly different rules. In an ideal world, an individual could contribute the maximum amount to both the 401(k) and an IRA. In reality, a person may be limited to how much or what account they can save in due to their own personal situation. A person might consider contributing to a 401(k) at least up to the amount the employer matches and also contributing to an IRA in accordance with their current savings strategy.
How does one start retirement savings?
If a person is interested in getting started, there are several experts who can consult on which strategy is best. A human resources representative may be able to help you enroll or change contributions and investments in a 401(k). A tax professional, while keeping the long-term goal in mind, can provide guidance on whether saving in a traditional or Roth is best. A financial adviser may be able to help an individual open an IRA and determine what investments are best for that person to support their goals and overall financial plan. A team approach works best.
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About the Author: Nicholas Erwin, CFP,® is a financial planning consultant at COUNTRY Financial®.
