Simplifying the Difference Between a 401(k) and an IRA
Are you wondering whether a 401(k) or an IRA is the better option for your retirement dollars? Let’s take a closer look at each of these plans to help you make a better decision for your circumstances.
What Is a 401(k)?
A 401(k) is an employer-sponsored retirement plan. Employers aren't obligated to offer one, but if they do, some make a matching contribution, up to a certain limit, that can help you fast-track your retirement savings.
Contributions to your 401(k) are made pretax, reducing your taxable income for that year. For example, if you earn $50,000 and contribute $10,000 to your 401(k), your income is reduced to $40,000 (before other adjustments). Taxes are applied upon withdrawal, and there are no withdrawal penalties if you are at least age 59½.
Keep in mind that you can no longer contribute to your 401(k) plan if you leave your job, but you can roll it over to an IRA and keep investing the funds.
Some 401(k) plans also offer a Roth option. This allows you to contribute after-tax dollars. Your employer’s contribution, however, will still be in pretax dollars.
What Is an IRA?
If you earn income, you can invest in an individual retirement account (IRA). There are several kinds of IRAs, but the most common are Traditional and Roth IRAs. An IRA typically provides greater options than a 401(k) when saving money for retirement. Investment choices include stocks, bonds, CDs, exchange-traded funds (EFTs), annuities and more.
When choosing between a Traditional and Roth IRA, consider whether you expect to be in a higher or lower tax bracket in the future. That’s because the tax rate matters for Roth IRAs at the time of contribution but for traditional IRAs at the time of withdrawal.
· Traditional IRA: Contributions are tax-deductible, but withdrawals in retirement are taxable. Note that if you or your spouse has an employer-sponsored retirement plan, your income may affect how much you can deduct for your traditional IRA contributions.
· Roth IRA: Contributions are not tax-deductible, but the withdrawals in retirement are tax-free.
How Much Can I Contribute Each Year?
While an IRA allows for greater investment choices, a 401(k) plan, if offered by your employer, allows for a much higher annual contribution limit. The 401(k) also gives people age 50+ the ability to make larger annual “catch up” contributions if they started saving for retirement later in life.
The 2021 401(k) contribution limits:
· Up to age 49: $19,500 ($58,000 with employer match)
· Ages 50+: $26,000 ($64,500 with employer match)
Note: contribution limit is 100% of your salary if it's less than the dollar limits listed above.
The 2021 Roth or traditional IRA contribution limits:
· Up to age 49: $6,000
· Ages 50+: $7,000
Note: To qualify for the full contribution limit to a Roth IRA, modified adjusted gross incomes must be below $125,000 (single filers) or $198,000 (married filing jointly).
Contributing to Both a 401(k) and a Roth IRA
Is contributing to both an option? Yes! Even if your employer offers a 401(k), you can also contribute to a Roth IRA, contributing up to the maximum limit for both.
I can help clear up any confusion surrounding your contributions or tax implications when it comes to your 401(k) or IRA investments. Schedule an appointment on my calendar to get started on a solid financial plan specific to your needs.