When it comes to saving for retirement, you have two options readily available to you: a 401(k) and an IRA. The difference between the two is not immediately apparent, but this short guide will help you understand and make an informed choice.
Both 401(k)s and IRAs are accounts that defer your income and help you save money for when you’re retired. The main differences between the two lie in how you obtain the account and how much money you can put into it.
Knowing the difference between an IRA and a 401(k) could be the key strategy in attaining your retirement goals.
This article will give you an in-depth look into both an IRA and a 401(k) and help you define the differences between the two.
Keep reading to become a retirement savings aficionado.
What is a 401(k)?
A 401(k) is a tax-advantaged investment account. Employers can create these accounts for their employees and often offer to match their employees’ contributions.
Because 401(k)s are employer-sponsored, you won’t get to choose which institution you bank with. You will, however, get to choose how much you contribute to your account. It’s recommended that you contribute the maximum amount that your employer will match.
These accounts offer certain tax advantages, depending on which type of 401(k) you create. All types of 401(k)s depend on income withholding.
Traditional 401(k)s collect pre-tax income, but you will have to pay taxes when you withdraw the money. Roth 401(k)s let you pay taxes upfront instead.
By reducing your taxable income, you can stay in a smaller tax bracket and pay less taxes each year. Essentially, you’re deferring your income to yourself rather than paying it to the government.
What is an IRA?
IRA stands for Individual Retirement Account. These accounts are set up as an individual through financial institutions, rather than through an employer. This means all contributions to the account will come directly from you and your investment choices, rather than your employer matching your contributions. It also means you have more control over who you bank with and how you invest your account.
IRAs offer similar tax advantages to 401(k)s. With an IRA, you can defer your taxes until withdrawal or grow your money tax-free. You can also stay in a smaller tax bracket by deferring your taxable income.
Due to their lack of employer contributions, It may seem that IRAs will grow much slower than 401(k)s-but with more control and more diverse investment options, they open the possibilities for a great return on investment (ROI).
Self-directed IRAs come with more responsibility. You can choose how and where you invest your money. Mutual funds used to be the main choice, but recent years have shown the rise of exchange-traded funds (ETFs).
You can choose to actively or passively manage your funds. Active funds attempt to beat the market, where passive funds aim to match the market.
The Bottom Line
IRA
- Offered by brokers or financial institutions- employers won’t help you
- More investment options, like mutual funds and ETFs
401(k)
- Offered by employers as a flexible alternative to pensions
- Employers set contribution limits by limiting what they’ll match
- Larger maximum annual contribution than an IRA
Both
- Help you save for retirement
- Help you stay in a smaller tax bracket by reducing taxable income
Now that you know the difference between these two retirement account options, you can choose which one works best for you. Bookmark this page for reference for later.
