When developing your retirement plan, understanding your options is essential to building a bright financial future to live out your golden years. Two popular options to house your retirement savings are a 401(k) and an Individual Retirement Account (IRA). Each account offers unique features and benefits that align with various financial circumstances and goals.
Whether you’re just starting your career or nearing retirement, understanding the differences and similarities between these two options will empower you to make the most of your retirement savings and ensure a secure financial future.
In this article, we’ll guide you through each retirement account so that you can feel confident making an informed decision about which option is best suited for you.
What is a 401(k) Account?
A 401(k) is a type of employer-sponsored retirement account. If your employer offers a 401(k) plan and you choose to enroll, you will contribute money directly from your paycheck. Since these contributions are made pre-tax, your taxable income is reduced – lowering your current tax bill to Uncle Sam.
Many employers offer a 401(k)-matching program for their team members. Your workplace may match up to 100% of your contribution amount, capped at a certain percentage point. For example, if you elect to contribute 5% of your income to your 401(k), your employer may match your 5% contribution. This is essentially free money! Always take advantage of an employer match so you can maximize your future savings and ensure you’re not leaving money on the table that could benefit you later.
The money in your 401(k) grows tax-deferred, meaning you don’t pay income tax on your investment gains until you withdraw the funds in retirement. Upon withdrawal, your distributions are taxed as ordinary income.
What is an IRA?
An IRA, or Individual Retirement Account, is a retirement savings option that you can open with any financial institution, like the credit union or through market-based investments. Your IRA is funded with contributions directly from your checking or savings account. You can even set up Payroll Deduction to have funds automatically withdrawn from your paycheck and deposited into your IRA, or you can set up Automatic Transfer on your preferred schedule.
There are a few different types of IRAs available to choose from, so you can make sure you’re selecting the right account for your needs. There are Traditional IRAs, Roth IRAs, as well as options for small business owners and self-employed individuals. We’ll primarily focus on Traditional IRAs throughout this article since they function like a traditional 401(k).
Like a 401(k), the money in a Traditional IRA grows tax-deferred, and withdrawals in retirement are taxed as ordinary income. Your contributions may be tax-deductible, depending upon your income and whether you are covered by an employer plan.
How Do 401(k)s & IRAs Differ?
Now that you know the basics of each account type, let’s take a closer look at some of the key differences and similarities between 401(k)s and IRAs.
-
Eligibility:
-
401(k):
These plans are made available by employers for their employees as a workplace benefit. You cannot open your own 401(k) at a financial institution like you can with an IRA. While 401(k) plans are a common benefit, not all companies offer one, as it is not federally mandated nor required by all states.
-
IRA:
Anyone who earns an income can open and contribute to an IRA.
-
Contributions & Contribution Limits:
-
401(k):
Contributions are automatically deducted from your paycheck and are pre-tax. While contribution limits can change annually by the IRS, in 2024, the maximum an employee could contribute was $23,000. This figure does not include contributions by the employer through matching programs. Additionally, individuals aged 50 and older could contribute an additional $7,500 annually through catch-up contributions.
-
IRA:
Contributions are made from your after-tax income, as set up via transfers from your chosen checking or savings account. Your contributions may be tax-deductible up to a certain threshold set forth by the IRS annually. In 2024, the maximum contribution was $7,000, with individuals aged 50 and older being able to contribute an additional $1,000 annually through catch-up contributions.
-
Employer Match:
-
401(k):
Employer matching is a common feature of 401(k) plans, often included as an added perk in your benefits package. Your workplace may offer a full or partial match up to a set threshold, such as 5%.
-
IRA:
Since IRAs are self-funded (meaning you control the account), there is no employer contribution.
-
Investment Flexibility:
-
401(k):
Control over your investments is typically limited to the overall plan’s options as selected by your employer. You may have limited flexibility with your investment choices.
-
IRA:
You can choose the IRA provider, type, and investments of your choice. However, you may want to consult with a financial advisor on higher-level investments such as stocks, bonds, mutual funds, and ETFs.
-
Taxes:
-
401(k):
Contributions are tax-deductible and reduce your taxable income since they are automatically deducted from your payroll.
Funds grow tax-deferred until withdrawn during retirement, where funds are taxed as ordinary income.
-
IRA:
With Traditional IRAs, contributions are tax-deductible. Funds grow tax-deferred until withdrawn during retirement, where funds are taxed as ordinary income.
-
Withdrawals:
-
401(k):
Withdrawals before the age of 59 ½ will incur a penalty fee for early withdrawals, typically 10% of the withdrawal amount (the IRS may allow select exceptions). Withdrawals may be made penalty-free after age 59 ½.
The IRS sets a Required Minimum Distribution (RMD), a mandatory annual withdrawal amount, once you reach a certain age. In 2024, the current age ruling for 401(k)s states RMDs must begin at age 73.
-
IRA:
IRA withdrawals, penalties, and age requirements are the same as those of 401(k)s. Withdrawals before the age of 59 ½ will incur a penalty fee for early withdrawals, typically 10% of the withdrawal amount (the IRS may allow select exceptions). Withdrawals may be made penalty-free after age 59 ½.
The IRS sets a Required Minimum Distribution (RMD), a mandatory annual withdrawal amount, once you reach a certain age. In 2024, the current age ruling for 401(k)s states RMDs must begin at age 73.
Which Account is Right for Me?
When determining whether a 401(k) or IRA will align better with your goals and needs, it doesn’t have to be an either-or decision. You can choose to use a combination of both accounts if you are eligible, so that you can take advantage of the key features of each option. However, chances are you only have a set number of dollars to devote to retirement savings, so you may still need to choose which account to prioritize.
Consider the following factors to help you determine which account, or combination of accounts, will work best for your unique circumstances and needs:
-
Employer Match Availability:
If your job offers a 401(k)-matching program, take full advantage of the free funds and max out the available contribution match before allocating additional funds elsewhere.
-
Income:
If you are a high earner, it’s often wise to prioritize your 401(k) due to the higher contribution limits than those available through IRAs.
-
Investment Flexibility:
If you want to be more hands-on in selecting your investments, IRAs tend to offer greater flexibility and autonomy compared to 401(k) plans. If you want to prioritize your 401(k) for its other benefits, you can use an IRA as a secondary savings plan to access wider investment options.
-
Target Retirement Age:
If you are planning an early retirement (before age 59 ½), a 401(k) might be your top priority. The IRS provides an exception allowing you to start making withdrawals if you leave your employer at or after age 55.
We’re Here to Help!
Both 401(k)s and IRAs offer distinct advantages that can play a significant role in your retirement strategy. Ultimately, the choice is yours, depending on your unique circumstances, goals, and the benefits made available to you. Consider how each option can complement your plan to provide a diversified retirement savings strategy.
If you want to learn more about retirement planning or have one of our financial advisors review your current strategy, we’re happy to help. Please stop by the Credit Union or call 410-687-5240 to schedule an appointment.