You want to be smart about saving for retirement, but deciding how to save can get tricky with all the options available to you. Should you invest in your employer's 401(k) plan? Is opening your own IRA the way to go? And what’s the deal with Roth accounts?
To help you answer the “how should I save for retirement?” question, we’ve laid out the basics of 401(k) plans and IRAs to highlight the key differences, plus the pros and cons of each, so you can decide which method of saving is best for you.
A 401(k) plan — or a 403(b) plan if you work for a nonprofit — is a retirement savings plan offered through your employer. In most cases, you authorize your employer to transfer a percentage of each paycheck to the 401(k). You choose among the investments offered in the plan and specify how much of your portfolio you’d like allocated to each investment option.
In 2019, the total amount you can contribute annually to your 401(k) plan is $19,000 if you’re under age 50, and $25,000 if you’re 50 or older. Your employer may choose to contribute additional funds by matching your contributions up to a pre-determined percentage. (For instance, your plan may match 401(k) contributions equaling up to 6 percent of your annual compensation.)
At your place of work, you may see two types of 401(k) plans being offered:
- Traditional 401(k): The traditional 401(k) plan is a popular way for businesses to help employees save for retirement. Contributions are made on a pre-tax basis, meaning the amount you contribute today can lower your taxable income for the year; contributions also grow tax-deferred. However, you’ll owe taxes on those contributions and their earnings when you withdraw funds later in life. Withdrawing before age 59½ incurs big tax penalties, and account holders must take required minimum distributions (RMDs) starting at age 70½.
- Roth 401(k): The Roth 401(k), which companies started offering in 2006, has grown rapidly in popularity over the years. Unlike the traditional 401(k), contributions are made with after-tax dollars, so they don’t help lower your taxable income today. However, you won’t pay taxes on contributions or their earnings when you withdraw during retirement. You'll face tax penalties on account earnings for withdrawing before 59½, and the same RMD rules at 70½ apply here.
Individual Retirement Accounts
Remember: Your 401(k) plan is sponsored directly by your employer. But you can also save for retirement by opening a specialized savings account called an Individual Retirement Account (IRA).
IRAs are offered through many financial institutions like banks, credit unions and brokerage firms. When you contribute money to an IRA, you can choose from a variety of investment options for your money.
In 2019, the total amount that you can contribute annually to all your IRAs is $6,000 if you’re under 50 and $7,000 if you’re 50 or older.
There are two common types of IRAs:
- Traditional IRA: When you contribute to a traditional IRA, the funds are often tax-deductible. This depends on whether you’re covered by a work-sponsored retirement plan, your filing status and your income. Like with a traditional 401(k) plan, you’ll owe taxes on contributions and earnings when you withdraw your money during retirement. Keep in mind that you’ll be required to start taking RMDs from your traditional IRA at age 70½.
- Roth IRA: As with a Roth 401(k), the contributions you make to a Roth IRA are generally not tax-deductible, but you enjoy zero taxation on contributions and earnings when you withdraw funds during retirement. Account holders can tap what they put into a Roth IRA at any time without penalty, but will face tax implications if they withdraw any earnings before age 59½. There's no RMD requirement while the Roth IRA account holder is still living. The IRS does place restrictions on who can contribute to a Roth IRA. Depending on your income and tax-filing status, you may be able to contribute up to the limit, only partially or not at all.
So, which is better?
The good news is you don’t have to choose one or the other. If you meet the eligibility requirements, you can contribute simultaneously to a traditional 401(k), Roth 401(k), traditional IRA and Roth IRA. However, it’s important to weigh the different characteristics of each type of account to determine what makes the most sense for your retirement mix. Here are some factors worth considering.
- IRAs tend to offer more investing options. IRAs typically offer hundreds of choices for investments, while a 401(k) plan’s options may be more limited. Depending on your risk tolerance and goals, you may want more options to choose from.
- IRAs may offer lower fees. 401(k) plans typically have higher fees than IRAs; make sure you’re reading the fine print to see how much these could add up to.
- 401(k) plans can lead to free money. If your employer offers a matching contribution to your 401(k) plan, that’s essentially free money. And those additional contributions can supercharge your savings at an incredible rate.
- The 401(k) wins on contribution limits. If all you have is an IRA, your annual savings are capped at just $6,000. But a 401(k) lets you save significantly more of your own money and your employer’s contributions.
- Your 401(k) likely includes a vesting schedule. In many businesses, you’re eligible for the full employer match only after you’ve worked at a company for several years. So if you change jobs sooner, you may sacrifice a portion of those matching funds.
- A Roth 401(k) bypasses Roth IRA income limits. If you don’t qualify for a Roth IRA or you want to contribute beyond its limit, you may think you’re stuck. But you can use your Roth 401(k) plan to access the same tax benefits without the income restrictions, and with a much greater annual contribution limit.
- Roth IRAs free you from RMDs. A traditional IRA and all 401(k) plans force you to take RMDs once you reach 70½. But if you’re looking for more control over your distributions, you can opt for a Roth IRA, which doesn’t require withdrawals during your lifetime.
At the end of the day, you’ll likely want to consider both an IRA and a 401(k) plan so you can take advantage of what both types of plans have to offer. What’s important is that you’re weighing factors like contribution limits, your future and present tax considerations, and your personal retirement goals to come up with the right strategy for you.
No investment strategy can guarantee a profit or protect against loss. All investing carries some risk, including loss of principal invested.