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401(k) vs. IRA – Complete Guide to Retirement Savings

Planning for retirement is a critical step in building the future you desire. It is no longer possible to rely on company-wide pensions or Social Security to meet all financial needs. However, if you begin to start saving for retirement now, you also give yourself the ability to stop working as hard sooner.

According to the U.S. Bureau of Labor Statistics, workers should plan to save 8 to 11 times their annual income for retirement (and that’s not including Social Security benefits). Yet, most people have very little savings in place.

What should you do? What are your options in retirement savings? No matter your age, how much you wish to put aside, or what your ideal retirement lifestyle is, consider the following strategies to start investing now.

The Power of Early Retirement Planning

The sooner you start investing in your retirement, the less money you need to save out of every paycheck to reach your goals.

When you put money into your retirement account now, that money starts to grow in valuable for you. The returns (or the growth in value) is reinvested into the account. That means that as long as those funds remain in place, it is going to compound on itself, growing at a much faster rate. With repeated investments, you grow your retirement account faster.

Early retirement planning provides you with numerous potential benefits:

  • A higher return on your investments is possible thanks to compounding interest.
  • You may be able to retire sooner, even years prior to your retirement age associated with Social Security benefits.
  • You can make more aggressive choices now because there’s more time for you to recoup any losses that do occur. That could mean bigger and bolder benefits.
  • It may help you reduce your overall borrowing costs.
  • Starting to retire now, decades before you are ready to do so, also enables you to tap into all of those employer contributions throughout your working years. That’s free money that the company is already planning to invest in you.

Tax-Advantages Accounts: Your Retirement Allies

The typical savings account is not an effective retirement strategy. The U.S. offers several tax-advantaged retirement accounts, though, and these open the door for significant tax benefits.

When you choose a tax-advantaged retirement account, you benefit directly from tax savings either at the time of investment or when you withdraw those funds. That’s key because it could mean saving thousands of dollars over the lifetime of your accounts.

There are two main options to consider: 401(k) and IRAs.

401(k) Overview

A 401(k) is a tax-advantaged retirement plan often established by a company to help employees contribute some of their wages to individual accounts. Employers typically provide an employer match, meaning they match some of the contributions employees make with their own.

As noted by the IRS, a 401(k) offers:

  • A portion of your paycheck is deposited into your retirement account before taxes are paid on it.
  • You have some control over the type of investments your money is put into, which are typically mutual funds like index funds or target date funds.
  • Your employer can match up to a certain amount.
  • You do not pay taxes on the funds deposited into your account at the time you receive them – rather, you pay taxes on the money when you start to pull them out of your retirement account to use during retirement.
  • You need to wait until you are 59 ½ to access the funds without paying a significant penalty.

Let’s explain:

Contribution Mechanics

With a 401(k), your employer will set up the account for you and others in the company. When payday comes, a portion of your paycheck (the amount you choose) is taken out of your pre-tax dollars and deposited automatically for you into your retirement account. You are not paying taxes on the funds now in the year you earn them.

Once you retire, you begin to pay taxes on the amount you withdraw. Typically, your tax bracket will be lower when you are older and not earning an income, meaning you may save money on taxes overall.

Employer Matching Contributions

This is one of the best features about 401(k)s. Your employer can match your contributions up to a certain amount. That means if you decide to invest $100 out of your paycheck, and your employer matches that by 50%, your contribution with each paycheck to your retirement account is $150.

Fees and Expenses Associated with 401(k) Plans

There are differences between plans, but you can expect for fees to range from 0.5% and 2%. This often dependent on the size of the plan within the company. Some companies cover these costs themselves while others pass them on to the company. The average annual fee is about 1%.

Vesting Schedules

Vesting refers to ownership of the funds. You always have full ownership of any money you contribute, but you may have to wait until you reach a certain number of years with the company to have full ownership of the employer contribution match.

A vesting schedule is an outline of how much ownership you obtain at various years with the company. For example:

  • 1 year of service: 0% vested
  • 2 years of service: 20% vested
  • 3 years of service: 40% vested

Employers can set their own schedules in terms of timelines and percentages. This is often done to encourage people to stay with the company longer.

Choosing Investments Within Your 401(k)

You can choose a wide range of investments within your 401(k) based on the plan established by your employer. This may include:

  • Index funds
  • Bond funds
  • Real estate funds
  • Large-cap and small-cap funds
  • Foreign funds

You have significant control in terms of choosing more aggressive or conservative investments, though you are not picking the actual companies to invest in.

Asset Allocation

Asset allocation is a term used to describe the percentage of assets you want your money to go into. For example, if you are older, you may want most of your money to go into more conservative funds. If you’re younger, you may want a higher percentage to go into more aggressive funds. You can adjust this as your needs change.

Target Retirement Date Funds

A target retirement date fund is a type of age-based investment fund. It allows you to choose funds that are appropriate based on your age and how long you have until you retire with less aggressive and risky investments as you get older.

Understanding IRAs

An Individual Retirement Account (IRA) is a type of tax-advantaged account designed to provide individuals with the ability to plan for retirement. Most often set up by a financial institution or bank, these are not typically provided by an employer, and that makes them significantly different in functionality.

Types of IRAs

There are two main forms of IRAs, as defined by the IRS:

  • A Traditional IRA: you save money for retirement with pre-tax dollars (money out of your check before taxes are levied). You pay taxes on those funds when you withdraw them.
  • A Roth IRA: you make contributions to this retirement account with after-tax contributions and do not pay taxes on them when the funds are withdrawn.

Traditional IRAs are best for those who are likely to be in the same or a lower tax bracket when they retire, while Roth IRAs may be best for those who are likely to be in a higher tax bracket later in life.

Contribution Limits and Eligibility

Annual contribution limits are in place for all who invest. Typically, you can contribute $7,000 per year in 2024 or $8,000 per year if you are over the age of 50. There is no age restriction on who can contribute to these accounts, and you can get started at any age.

Income Phase-Out Limits for Roth IRA Contributions.

Anyone is eligible to contribute to either account, but the Roth IRA is limited based on income. Your income must be below a certain level to qualify. For tax year 2024, that income level is under $161,000 for single tax filers or $240,000 for those married filing jointly. If you make between $146,000 and less than $161,000, you may have your contributions reduced.

IRA Investment Options

IRAs provide account holders with numerous types of investment methods. There are almost no limits to consider here. That includes stocks, bonds, C.D.s, mutual funds, and ETFs. You gain the ability to pick and choose more freely.

The Ultimate Showdown: 401k vs IRA Plan Comparison

IRA vs 401K
IRA401K
Employer MatchNoYes
Tax Pre WithdrawalNoYes
Tax Post WithdrawalYesNo
Employer sponsoredNoYes
Maximum contribution$7,000 per year through age 50, $8,000 per year after 50Percentage of wages as set by employer

Which Retirement Savings Option Should You Choose?

There are many factors to take into consideration when it comes to choosing a retirement savings option. First, know that any type is better than none. If you have a 401(k) available to you through your employer, it is often wise to seek out these accounts because of the employer contribution match. However, some employers may still be willing to contribute to your IRA if you ask them to do so.

Consider the underlying investments, the amount of control you desire, and your long-term goals to determine which retirement savings option is best for your needs.

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