Remember starting your first job? Retirement seemed like it was a lifetime away. You were looking forward to receiving a steady paycheck and advancing your career. But time flies. Now you find yourself wondering how to save for your golden years.
Both a 401(k) and IRA are financial tools for retirement savers. The main difference is that employers offer 401(k)s, but individuals open IRAs. If you’re ready to put money aside for the future, but don’t know whether to choose a 401(k) or an IRA, it can be helpful to understand the differences.
A 401(k) is an employer-sponsored retirement plan. The name comes from a section of the IRS tax code. Companies offer 401(k) plans as part of their total compensation package, included with their wages and benefits. These plans allow employees to make pre-tax contributions from their salaries towards a retirement savings plan. You typically will choose from a selection of investment opportunities (think mutual funds, stocks, bonds, etc.) provided through your employer’s plan, and decide how much you will allocate from each paycheck. Did you know the money you contribute to a 401(k) lowers your taxable income? For example, if you make $80,000 a year but contribute $4,000 to your 401(k), this lowers your taxable income to $76,000.
An Individual Retirement Account (IRA) is a retirement plan provided by many banks and financial service providers. Anyone with eligible earned income (compensation from employment) can open an IRA, and you don't have to depend on an employer to establish one. Compared to a 401(k), an IRA offers more investment options because it’s not limited to your employer’s plan. There are two different kinds of IRAs: Traditional and Roth.
Like a 401(k) account, Traditional IRAs are funded with pretax dollars. With a Traditional IRA, you don’t pay taxes on the amount you pay into the account, but you are taxed on withdrawals, typically after you retire. When you begin to make withdrawals, those amounts must be included in your taxable income. People typically need to be 59 1/2 years old to take funds from their IRA without a penalty (10% on the amount withdrawn, plus taxes).
With a Roth IRA, you pay taxes on the amount you contribute upfront, but your withdrawals are tax-free, in most cases. As long as the account is five years or older, you can take out contributions at any time. Roth IRAs offer the benefit of tax-free growth and tax-free withdrawals in retirement. One potential disadvantage is that you're contributing post-tax money, which means a bigger hit on your current income, but the longer you leave the money in the account, the greater its value can be down the road, so taking money out tax-free can be a plus. A Roth IRA can also be used as a savings vehicle for college.
Company Match - a 401(k) Perk
A 401(k) may provide an employer match, but an IRA does not. If your employer offers a 401(k) with a company match, it makes sense to take advantage of this offer. The match depends on your employer. For example, say your employer provides a 50% match for up to 5% of salary. That means, if your salary is $80,000, your employer will put in $2,000, as long as you also contribute at least $4,000. If you can, contribute enough to get the maximum match each year.
Every year, the IRS places limits on how much you can contribute to a 401(k) and IRA. A 401(k) typically allows higher annual contributions than IRAs. It’s best to consult with your tax advisor to ensure you have the most current information on contribution limits.
Both IRAs and 401(k)s have fees that can vary. If you’re not sure what the costs are to manage your account, do your research on your account’s fees so you know the full picture.
If you change jobs, you can roll over your 401(k) from your employer into a personal IRA or consolidate your 401(k) into your new employer’s plan. You also can just keep your 401(k) with your former employer, but doing so may limit any further fund management or growth potential.
At Citizens Bank we can help guide you to make the best decisions for your financial future and assist you with your rollover and IRA needs. We are here to help you save for tomorrow. Stop by your local branch to learn about retirement saving options and more. You can also check out our more detailed Roth vs. Traditional IRA blog post for even more information.