Saving for retirement is one of the vital financial priorities we must succeed in during our lives. So it’s a good idea to start planning your retirement early to ensure your financially secure retirement. When it comes to retirement savings, the two most common accounts that come to mind are a 401(k) and an IRA.
A 401(k) plan is a tax-advantaged retirement savings plan that allows employees to divert a portion of their salary into long-term investments. It is named after a section of the Internal Revenue Code of the United States.
When employees enroll in a 401(k), they agree to have a portion of each paycheck deposited directly into an investment account. In addition, those who contribute to a 401(k) plan receive a tax break on their contributions. Contributions are deducted automatically from employee paychecks and invested in funds of the employee's choice from a list of available options.
Individual retirement accounts (IRAs) are non-employer-sponsored retirement savings accounts. Most banks and brokerage firms will allow you to open an IRA. Roth and Traditional IRAs are the two main types of Individual retirement accounts.
A Roth IRA allows you to contribute income that has already been taxed. As a result, your money grows tax-free, and you can generally withdraw it tax- and penalty-free after the age of 59,5. A Traditional IRA allows you to contribute pre- or post-tax dollars, your money grows tax-deferred, and withdrawals are taxed as current income once you reach the age of 59,5.
There are also SEP IRAs, or Simplified Employee Pensions, that are a flexible retirement account option for self-employed individuals.
401(k) vs. IRA
To begin, it is critical to understand that the Internal Revenue Service (IRS) establishes annual contribution limits. An employer-sponsored 401(k) plan allows you to contribute significantly more to your retirement savings than an IRA.
For 2021 the elective contribution limit for employees who participate in a 401(k) is $19,500, whereas IRA account holders are allowed to contribute up to $6,000 per year to both accounts. If you are over the age of 50, you are allowed to make additional or catch-up contributions of up to $1,000 per year for IRAs.
The real benefit of a 401(k) is that it is protected from creditors and lawsuits in most states. What will happen to your retirement funds if you declare bankruptcy or file a lawsuit? The 401(k) is more secure from creditors than the IRA. IRA accounts have a lower level of security.
If you want more flexibility in your retirement planning, an IRA may be a better option than a 401(k). It is easier to obtain. You can open an IRA online in 15 minutes or less. You contribute to an IRA if you have earned income in a given year.
That is not the case with a 401(k) plan; a 401(k) plan offered by an employer may have a waiting period. In some cases, new employees may be required to wait up to six months or a year before opening a retirement account.
While they may be more difficult to obtain, 401(k) plans compensate for this by offering the possibility of free money. In other words, many employers will add up your contributions up to a certain amount. For example, if you contribute 4% of your salary, your employer may offer 2%, 3%, or 4% as an incentive to help you save. That's free money and a quick fund on your investment.
An IRA, on the other hand, is entirely your responsibility, and your funds will consist solely of what you contribute and any earnings on those contributions.
If you withdraw money from an IRA or 401(k), you will almost certainly be charged taxes and penalties. However, depending on how your employer's plan is structured, your 401(k) may allow you to take out a loan. You will have to pay interest, as with any other loan, and you will have a repayment period of no more than five years. However, this is not allowed with IRAs.
Each of these retirement plans offers significant tax advantages, and you can have both simultaneously. The primary distinction between 401(k)s and IRAs, as seen above, is that 401(k)s are offered by employers, whereas IRAs are opened by individuals through brokers or banks. IRAs typically provide more investment options, whereas 401(k)s permit greater annual contributions.
What are you waiting for if you haven't started saving for retirement or if you're saving less than you should? Now that you've learned more about which retirement account may be the best fit for you, it's time to put your savings strategy into action. Understanding the distinctions between the two allows you to make more informed decisions and ensure they are getting the most value out of your investment choices.