Hi, I’m Bette Hochberger, CPA, CGMA. Happy Finance Friday! Today I will discuss the differences between an IRA and a 401(k). Both have tax benefits for retirement savers, but it’s always great to find out which one is right for you. Let’s dive in!
As I mentioned above, both 401(k)s and IRAs, including Roth IRAs, provide valuable tax benefits, and it is often possible to contribute to both types of accounts. The primary distinction lies in the fact that employers offer 401(k)s, whereas individuals independently open IRAs through brokers or banks.
IRAs generally offer a wider range of investment options, while 401(k)s allow for higher annual contributions. In 2023, 401(k)s have a contribution limit of $22,500 ($30,000 for individuals aged 50 or older), whereas IRAs have a limit of $6,500 ($7,500 for individuals aged 50 and older).
IRA (Individual Retirement Account)
An IRA is a type of retirement savings account that provides individuals in the United States with tax advantages to encourage long-term savings for retirement. Individuals typically open IRAs on their own, usually through financial institutions such as banks, brokerage firms, or mutual fund companies.
- Tax Advantages: One of the main benefits of an IRA is the potential for tax advantages. Traditional IRAs offer tax-deferred growth, meaning that contributions made to the account may be tax-deductible in the year they are made, and any earnings within the account grow tax-free until withdrawn in retirement.
- Contribution Limits: The IRS sets annual contribution limits for IRAs.
- Withdrawal Rules: Traditional IRAs generally incur income tax on retirement withdrawals, with a 10% early withdrawal penalty before age 59½ (exceptions apply).
- Portability: IRAs are portable and can be transferred or rolled over into different types of retirement accounts. For example, if you change jobs or retire, you can roll over your 401(k) into an IRA to continue benefiting from tax advantages and have more control over your investments.
A 401(k) is a type of employer-sponsored retirement savings plan in the United States. It allows employees to contribute a portion of their pre-tax salary to a retirement account.
- Employer-Sponsored: 401(k) plans are established by employers for their employees. The employer sets up the plan, determines the available investment options, and may offer certain contributions or matching contributions.
- Tax Advantages: Contributions made to a traditional 401(k) are made with pre-tax dollars, which means they are not subject to income tax at the time of contribution. The contributions and any investment gains grow tax-deferred until withdrawals are made in retirement. However, when withdrawals are taken in retirement, they are subject to ordinary income tax.
- Employer Contributions: Many employers offer a matching contribution as an incentive for employees to participate in the 401(k) plan.
- Contribution Limits: The IRS sets annual contribution limits for 401(k) plans.
- Investment Options: The specific investment options available within a 401(k) plan depend on the plan’s administrator. Typically, there is a range of investment choices, such as mutual funds, index funds, and target-date funds.
- Portability: When leaving a job, individuals have options for their 401(k) funds. They can choose to leave the funds in the employer’s plan, roll them over into an IRA, or transfer them into a new employer’s 401(k) plan if allowed.
So, still, having trouble deciding which is best for you? Here’s a quick way to determine where to contribute first:
It is recommended to contribute enough to maximize the match if your employer provides a 401(k) plan with a company match. This match can potentially yield a 100% return on your investment, depending on the specific 401(k) plan.
If your employer does not provide a company match for your retirement savings, it may be beneficial to prioritize other options before considering a 401(k). Starting with an IRA or Roth IRA can offer advantages such as a wider range of investment choices and the potential avoidance of administrative fees associated with certain 401(k) plans.
By opening an IRA through a broker, you gain access to a diverse selection of investments. After contributing up to the limit allowed for an IRA, you can then consider funding your 401(k) to take advantage of its pre-tax benefits.
If you’re unsure about which type of IRA is most suitable for you, you can refer to a guide on choosing between a Roth IRA and a Traditional IRA. This approach allows you to optimize your retirement savings strategy.
Note that rules and regulations for IRAs and 401(k)s can be complex and subject to change. Consult a tax professional to fully understand the benefits, considerations, and best strategy for your specific circumstances.
I hope you learned something new today. As always, stay safe, and I will see you next time.