Saving for retirement is an important goal, especially if you have your debt under control and the extra savings available. But choosing to invest in either a 401(k) vs an IRA can be confusing. There are different income and tax factors for each, so how do you know which one you should use?
Let’s take a look at the differences between an IRA vs 401(k) in terms of how much you can contribute, how they’re taxed, and the pros and cons.
Individual Retirement Account: Traditional vs. Roth
An Individual Retirement Account (or IRA for short) allows you, as an individual, to contribute and save up money for your future retirement. You can set up an account at your bank or other financial institution.
Depending on the type of the IRA you choose, there are several ways to benefit from tax-free growth or tax-deferred savings. There are two main types of IRAs with different tax advantages of each.
A Traditional IRA is has two main benefits: you may qualify for a tax deduction on the money you contribute and the income earned in the account accumulates on a tax-deferred basis. You can start taking withdrawals at age 59 ½, at which point the money will be taxed as regular income.
With a Traditional IRA, there is no income limit, so you can open an account and save for retirement no matter how much money you earn. The maximum amount you can contribute in 2016 is $5,500 for individuals under 50 years old, or $6,500 for individuals 50 years or older.
You’ll want to choose a Traditional IRA if your income is too high to contribute to another type of retirement plan, or in the event you want to receive a yearly tax deduction on your income taxes.
The main drawback is that you likely have no way of knowing what your income tax bracket will be when you reach retirement age, and therefore, could be paying out a large amount of taxes when you withdraw funds. In addition, a Traditional IRA comes with a Required Minimum Distribution (RMD) when you hit age 70 ½, forcing you to take out funds on a yearly basis.
A Roth IRA has opposite tax advantages from the Traditional IRA. Instead of receiving a tax deduction and contributing pre-tax funds, the money earned and withdrawn from a Roth IRA is completely tax-free in retirement. You may also take out money to use penalty-free for qualified purchases, like buying your first home or higher education.
Not everyone qualifies for a Roth IRA, though, as there are certain income limitations. In 2016, you must have an adjusted gross income AGI) of less than $116,000 as an individual or $183,000 for a married couple filing jointly.
Like with the Traditional IRA, the maximum amount you can contribute in 2016 is $5,500 for individuals under 50 years old, or $6,500 for individuals 50 years or older. You’ll want to choose a Roth IRA if you’re a young adult and have many years ahead of you to save for retirement, as your tax situation will likely drastically change as you reach retirement age.
You may also be interested in forgoing the tax deduction in favor of tax-free withdrawals in the future. Unlike a Traditional IRA, there are no Required Minimum Distributions, so you can leave the funds in your account as long as you wish.
The main drawback is that there’s an income limit, but as a young adult, you will likely not be affected by this limitation.
Employer-sponsored plan: 401(k)
There are many types of employer-sponsored retirement plans and a 401(k) is one of the most popular ones. It allows you, the employee, to save and invest part of your paycheck each payment period before taxes are taken out.
There are several different types of 401(k)s available, but we’re going to focus on the most common one.
A Traditional 401(k) is the most common plan and allows both employers and employees to contribute pre-taxed money into a retirement account for the benefit of that employee. This means you won’t have to pay taxes on that money during the year you earned it, but instead, pay them when you withdraw it during retirement.
You may choose how your funds are invested and can only access them if you change jobs or reach retirement age. In 2016, employees who participate in a Traditional 401(k) are allowed to contribute up to $18,000 of pre-tax income, plus an additional $6,000 for individuals 50 years or older.
You’ll want to choose a Traditional 401(k) versus another type of 401(k) if you want to defer a larger portion of your income from paying taxes, and/or your employer offers a match to contribute an additional amount as you participate in the program. This is like receiving “free money” and can help you grow your retirement wealth quickly.
A similar drawback like with a Traditional IRA, the funds in your Traditional 401(k) will be taxed as regular income as you withdraw them during retirement age.
IRA vs. 401(k): Final thoughts
Use the pros and cons listed here to help decide which type of retirement account is best for your financial situation. In most cases, you’ll want to participate in your employer’s 401(k) or other sponsored retirement plan whenever possible since the contribution limits are higher and many employers offer a match.
If that’s not an option, you’ll want to check out the Roth IRA if you’re younger and expect to be in a higher tax bracket at retirement. If you’re an older adult, a Traditional IRA may be the best choice.
The biggest difference between a 401(k) and a Roth IRA are the tax implications and how that affects your contributions and withdrawals. A 401(k) is funded with pre-tax dollars, allowing a credit on your taxes, while a Roth IRA is funded with after-tax money and does not allow for any tax credits.
However, you will have to pay taxes on the funds you withdraw from your 401(k) during retirement, based on your current income tax bracket (which could be substantial after 40+ years on the job), while any money withdrawn from a Roth IRA during retirement is completely tax-free.
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