When planning for retirement, there are a number of different account types to consider.
And two of the most popular are 401(k)s and IRAs (individual retirement accounts.)
401(k)s and IRAs each have advantages and disadvantages that can influence your long-term financial success. This guide will examine the intricacies of both account types, providing you with essential information to make wise decisions concerning your retirement savings plan.
We'll begin by exploring the key differences between traditional and Roth 401(k) plans and employer matching contributions—a critical factor in maximizing your workplace retirement account. Next, we'll discuss various types of IRAs (Traditional, Roth, SEP & SIMPLE) and investment vehicles within an IRA, such as mutual funds or exchange-traded funds (ETFs.)
Next, when comparing these popular retirement accounts, it’s essential to understand annual contribution limits and catch-up contribution limits. We will also examine tax implications associated with both traditional and Roth versions of 401(k)s and IRAs so that you can better understand how they may affect your taxable income now and during retirement.
Finally, we’ll provide guidance on maximizing your employer match while offering practical strategies for managing your retirement funds throughout all stages of life. With this comprehensive overview in hand, you’ll be able to confidently select a retirement plan that best suits your needs and objectives.
Understanding 401(k) Plans
A 401(k) retirement plan is a tax advantaged retirement savings account offered by employers that may include an employer match. Though details vary by plan, some key elements of a typical 401(k) plan include:
Choose from a limited menu of investment options that can include mutual funds, index funds, ETFs, and target-date funds.
Choose between traditional or Roth contributions—each with unique tax advantages.
Receive an employer matching contribution to incentive you to save money for retirement.
Some employer matching contributions may be subject to vesting requirements.
Exploring Individual Retirement Accounts (IRAs)
IRAs are tax-advantaged retirement savings accounts. Some IRAs are established by individuals, while others are established by employers.
There are four types of IRA accounts: Traditional, Roth, SEP, and SIMPLE, each with unique benefits to consider.
Traditional IRA: Can only be established by an individual, not an employer. Contributions may be tax-deductible depending on your income level, and earnings grow tax-deferred until withdrawal at retirement age, when they are taxed as ordinary income. Accounts are subject to required minimum distributions (RMDs.)
Roth IRA: Can only be established by an individual, not an employer. Contributions are made with after-tax dollars, and qualified withdrawals during retirement are tax-free. Accounts are not subject to required minimum distributions.
Simplified Employee Pension (SEP) IRA: Designed for self-employed individuals and small business owners who want to provide employees with a workplace retirement account option. Contributions are made by the employer, not the employee.
Savings Incentive Match Plan for Employees (SIMPLE) IRA: A simplified employer-sponsored plan that allows employers and employees to contribute towards an employee's retirement savings.
With an IRA, you can invest in various assets such as mutual funds, stocks, bonds, ETFs, and REITs to suit your individual retirement savings needs.
Overall, IRAs can be a savvy approach to saving for retirement and can help you reach your financial goals.
Comparing Contribution Limits for Both Options
One key difference between 401(k)s and IRAs is their contribution limits.
In general, 401(k)s let you save more money per year than IRAs, but be sure to understand the details with each option.
Annual contribution limits for both types
Traditional & Roth 401(k): Employees can save up to $22,500 in 2023. ($30,500 for those aged 50 and over.)
Traditional & Roth IRAs: The combined annual limit is $6,500 for 2023. ($7,500 for those aged 50 and over.)
Catch-up contribution allowances
If you're 50 or older, you can make extra "catch-up" contributions to your retirement accounts:
Traditional and Roth 401(k)s: You can save an extra $7,500 per year for 2023.
Traditional and Roth IRAs: You can save an additional $1,000 per year for 2023.
Tax Implications Between Traditional & Roth Versions
Traditional 401(k) and IRA Tax Benefits
Pre-tax contributions: Lower taxable income now; save money on income taxes.
Tax-deferred growth: Investments grow without annual capital gains, dividends, or interest taxed until retirement.
Distributions taxed: Retirement distributions are taxed as ordinary income.
Roth 401(k) and Roth IRA Tax Advantages
After-tax contributions: Pay taxes today but receive withdrawals tax-free during retirement.
Tax-deferred growth: Investment earnings grow tax-deferred, just like traditional accounts.
Tax-free distributions: Qualified distributions are tax-free during retirement.
Generally, advisors will recommend using traditional accounts if you are a high earner with a high tax rate today. Alternatively, many advisors recommend that low earners in a low tax bracket today use Roth accounts.
At its core, the decision between traditional and Roth involves comparing your tax rate today against your expected tax rate during retirement. If you expect higher taxes during retirement, use Roth accounts now to lock in your lower tax rates. But, if you expect lower taxes during retirement, use traditional accounts to benefit from a tax deduction at a higher current rate, and then you can distribute the money during retirement at a lower rate.
Maximizing Employer Matching Programs
One of the most significant benefits of an employer sponsored plan such as a 401(k) is the employer matching contributions. Don't leave free money on the table—take advantage of your employer's retirement plan matching program.
Understand the Rules
Familiarize yourself with your specific employer matching rules, including vesting schedules, and matching percentages.
How To Optimize Your Contributions
Contribute More: Aim to save the full amount needed to receive the maximum employer match. For example, if your employer matches 100% of the first 6% of contributions, you would need to contribute at least 6% to receive the full 6% match.
Budget Smart: Adjust your monthly budget to meet contribution goals without sacrificing other financial priorities.
Stay Informed: Keep track of changes in company policies regarding matches by regularly reviewing plan documents and staying updated through HR.
For more information on retirement accounts and overall contribution limits, check out IRS.gov.
Understanding Withdrawal Rules, Penalties, and Exceptions
One important factor to consider when using tax-advantaged retirement accounts is that there are certain rules around when you can withdraw the funds. At a high level, these accounts are designed to help you save money for retirement. So, to incentivize that, there are certain penalties you can face when withdrawing from your account before retirement.
Here are some things to consider:
Traditional 401(k)s: 10% penalty on top of ordinary income taxes if funds are withdrawn before age 59.5. After 59.5, all withdrawals are taxed as ordinary income with no additional penalty.
Roth 401(k)s: 10% penalty if funds are withdrawn before age 59.5 and before 5 years from your first deposit. All withdrawals after 59.5 and 5 years of account opening are tax and penalty free.
Traditional IRA: 10% penalty on top of ordinary income taxes if funds are withdrawn before age 59.5. After 59.5, all withdrawals are taxed as ordinary income with no additional penalty.
Roth IRA: Different rules for earnings vs. contributions. You can withdraw your contributions penalty and tax-free at any time. For earnings, you must be 59.5 or older AND have had the account for more than five years to avoid penalties. Otherwise, earnings withdrawals can incur a 10% penalty and taxes. After 59.5 and 5 years from account opening, all withdrawals are tax and penalty free.
With every account type, there are specific exceptions to the 10% early withdrawal penalty. Please review the IRS website for the most up-to-date guidance on penalty exceptions.
Choosing Between 401(k) and IRA Investment Strategies
When deciding between a 401(k) or an IRA, you have to consider your unique goals.
Contribution Limits: Consider the annual contribution limit for each type of account.
Taxation Implications: Evaluate the main difference between traditional and Roth versions of each type of account and how they affect income taxes.
Eligibility Requirements: Determine if you meet the eligibility requirements based on annual household income levels.
At a high level, many advisors will recommend focusing on a 401(k) to get the full employer match, then considering an IRA for additional savings. But, if you then max out your IRA contribution and are still looking to save more for retirement, many advisors recommend refocusing on your 401(k) for additional savings because the contribution limits are much higher.
Diversifying Investments for Greater Flexibility
An ideal approach may involve contributing to both 401(k)s and IRAs, providing greater flexibility in contribution amounts, investment options, and other unique advantages.
Roth accounts may be beneficial if you anticipate being in a higher tax bracket during retirement, while those expecting to be in a lower one may opt for traditional accounts.
Ultimately, remember to assess your savings goals and current taxable income when choosing between a traditional or Roth account and an IRA or 401(k), and consider balancing contributions across different types of accounts to have added flexibility during retirement.
Properly planning for retirement is crucial, and understanding the differences between 401ks and IRAs is key. These two savings options offer unique advantages and may cater to different types of investors. Gaining in-depth knowledge about the options can set one on the right path towards a secure retirement.
Both offer unique benefits and drawbacks, so consider factors like employer matching contributions, taxes, investments, and your personal financial goals.
When exploring contribution limits, consider the maximum contribution that is allowed each year and whether it fits with your goals. If you have an employer match, make sure to take advantage of this option as much as possible, as this can potentially double your savings.
Overall, taking the time to explore contribution limits and investment choices is essential for making an informed decision around 401ks and IRAs that aligns with your goals. So, start saving for retirement now and reap the benefits later.