IRAs vs. 401(k)s: Explained

Individual Retirement Accounts (IRAs) and 401(k)s are two popular types of retirement-savings accounts. People may open and fund the accounts with savings during their working years and withdraw money from the accounts in retirement to pay for living expenses.

An IRA is an account that you can open and contribute to on your own, while 401(k)s are generally only offered as a workplace benefit.

Generally, people who work in the private sector have at least one of these accounts, and many people have several different retirement accounts.

Differences

Although they can both serve the same purpose, the accounts have some important distinctions:

 

 

IRAs

401(k)s

How do you open an account?

Open an account with a financial institution and deposit funds.

Your employer must sponsor an account, and you sign up through human resources.

How do you contribute?

Send money to your account.

Set up automatic payroll deductions.

When can I use the money?

Not until age 59½, other than a few exceptions.

Not until age 59½, other than a few exceptions.

Perks

Typically can choose from a wide menu of investment options.

Many employers match your contributions up to a certain amount.

Maximum annual contribution

$6,000 in 2019.

Those 50 or older may contribute an additional $1,000 for $7,000 total.

 $19,000 in 2019.

 

Benefits

Both types of accounts can be great options for retirement savings thanks to the advantages they provide, including:

  • Potential growth: Both IRAs and 401(k)s typically offer a range of investment options you can consider, so your money grows over time.
  • Tax advantages: Both types of accounts let you avoid paying taxes on your money’s growth while it’s in the account.
  • Chance to build your wealth: By contributing regularly over time and letting your money grow, you can use either account type to meet your retirement goals.

 

Traditional vs. Roth

One of the most significant advantages of the accounts is the chance to benefit from preferential tax treatment. However, exactly how that tax treatment works depends on whether you save in a so-called “traditional” account or “Roth” account.

Here are the basic differences in the tax treatment:

  • Traditional accounts:
    • You save —> pretax dollars
    • You pay —> income taxes on withdrawals in retirement
  • Roth accounts:
    • You save —> after-tax dollars
    • You pay —> no taxes on withdrawals in retirement

 

Good to know

Although it’s often fine to save in several different types of accounts, some special restrictions apply to higher earners.

Restrictions on Roth contributions:

  • If you earn more than $122,000 as a single person or more than $193,000 as a couple in 2019, then you may not be able to contribute the full $6,000 to a Roth IRA account.
  • If your income is above $137,000 as a single person or $203,000 as a couple, then you cannot contribute anything to a Roth IRA.

 

Limits on traditional IRA tax benefits:

  • If you or your spouse has access to a retirement plan at work—such as through a 401(k)—and you earn more than $64,000 as a single person or more than $103,000 as a couple, then you may lose some or all of the tax benefits of contributing to a traditional IRA.
  • For many savers, that means it doesn’t make sense to contribute to both a 401(k) and a traditional IRA.

 

When to start

Whether you save in an IRA, a 401(k), or both, the best time to start is usually as soon as you can. If your employer matches your contributions to your workplace retirement plan, make sure you save at least enough to capture the full amount of any match. Many experts recommend aiming to save 15% of your annual income during your working years.

 

Key takeaways:

  • IRAs and 401(k)s are two main types of retirement savings accounts.
  • The main difference is that 401(k)s must be sponsored by an employer, while you can set up an IRA on your own with a financial institution.
  • IRAs and 401(k)s can both come in two different types—“traditional” and “Roth”—with different tax advantages.
  • Although you may generally use more than one type of account, higher earners may not qualify for all of the tax benefits of traditional and Roth IRAs.
  • Whatever type of account you choose, it’s important to start saving aggressively for retirement as soo
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