401(k)s and individual retirement accounts (IRAs) play a major role in many people’s plans for retirement. While both offer great retirement benefits, there are some key differences between the two.
401(k)
A 401(k) is a retirement plan offered by employers, allowing employees to save up for their nest egg years. Contributions are deducted directly from employees’ pre-tax salary and invested in funds of their choice. This way, employees enjoy the benefit of lower taxable income. The maximum limit for contributing to this type of plan is $18,500 a year, with the exception of $24,500 a year for people aged 50 or more.
In addition to employees saving a specific amount each year, some employers offer to match a proportion of that savings. This is where the plan becomes all the more attractive. Take this example: your annual salary is $30,000 and you decide to contribute 5% of it to a 401(k) plan; your total annual savings would be $1500. The same savings could go up to $2400 if your employer offers to contribute up to 3% of your salary.
IRA
In an individual retirement account (IRA), money, as well as stocks, mutual funds or bonds can be invested. Individuals can contribute up to a maximum of $5,500 a year to these accounts. Meanwhile, people aged 50 or above are given the advantage of adding $1000 extra.
There are two common types of IRAs—Traditional IRA and Roth IRA. The key difference between the two is that contributions in traditional IRAs are tax deductible, while Roth IRA contributions are made using post-tax income. So, while traditional IRAs will lower an individual’s tax bill, Roth IRA contributions are not taxed on withdrawal.
Advantages of a 401(k)
The maximum amount individuals can contribute to a 401(k) plan is much higher than an IRA. Retirement savings get a huge boost if employers offer to match contributions. Add that to the benefit of no eligibility limitation based on income. Though traditional IRAs have no income eligibility, Roth IRAs lay down certain income eligibility rules. Also, a 401(k) plan reduces employee tax bills, since contributions are made on pre-tax income.
Advantages of an IRA
IRAs offer a much wider range of investment options to choose from than a 401(k). Roth IRAs also offers tax-free withdrawals during retirement, something not available for traditional IRAs or even a 401(k). Additionally, early withdrawals from an IRA are much easier than from a 401(k), where withdrawals before the age of 59.5 are taxed and there’s a 10% penalty on the amount withdrawn.
However, there are a few exceptions to this case. Roth IRAs offer the ease of withdrawing money at any time without having to face penalties or taxes, except for investment earnings. In comparison, early withdrawal is a little difficult in traditional IRAs, where penalty-free withdrawals are allowed only in certain cases like buying a new house for the first time, medical and education expenses, etc. And, unlike a 401(k) or traditional IRA, Roth IRAs do not involve required minimum distributions (RMDs) after the age of 70.5.
Which One Should You Choose?
If income allows, an individual can invest in both these retirement instruments to obtain maximum benefits. Even if an employer match is not available, a 401(k) plan remains lucrative because of the significantly higher contributions that it allows compared to an IRA. However, with an IRA, individuals can choose from a wide variety of investment options and enjoy numerous flexibilities.
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401(k) vs. IRA: Which is Your Path to a Successful Retirement?
401(k)s and individual retirement accounts (IRAs) play a major role in many people’s plans for retirement. While both offer great retirement benefits, there are some key differences between the two.
401(k)
A 401(k) is a retirement plan offered by employers, allowing employees to save up for their nest egg years. Contributions are deducted directly from employees’ pre-tax salary and invested in funds of their choice. This way, employees enjoy the benefit of lower taxable income. The maximum limit for contributing to this type of plan is $18,500 a year, with the exception of $24,500 a year for people aged 50 or more.
In addition to employees saving a specific amount each year, some employers offer to match a proportion of that savings. This is where the plan becomes all the more attractive. Take this example: your annual salary is $30,000 and you decide to contribute 5% of it to a 401(k) plan; your total annual savings would be $1500. The same savings could go up to $2400 if your employer offers to contribute up to 3% of your salary.
IRA
In an individual retirement account (IRA), money, as well as stocks, mutual funds or bonds can be invested. Individuals can contribute up to a maximum of $5,500 a year to these accounts. Meanwhile, people aged 50 or above are given the advantage of adding $1000 extra.
There are two common types of IRAs—Traditional IRA and Roth IRA. The key difference between the two is that contributions in traditional IRAs are tax deductible, while Roth IRA contributions are made using post-tax income. So, while traditional IRAs will lower an individual’s tax bill, Roth IRA contributions are not taxed on withdrawal.
Advantages of a 401(k)
The maximum amount individuals can contribute to a 401(k) plan is much higher than an IRA. Retirement savings get a huge boost if employers offer to match contributions. Add that to the benefit of no eligibility limitation based on income. Though traditional IRAs have no income eligibility, Roth IRAs lay down certain income eligibility rules. Also, a 401(k) plan reduces employee tax bills, since contributions are made on pre-tax income.
Advantages of an IRA
IRAs offer a much wider range of investment options to choose from than a 401(k). Roth IRAs also offers tax-free withdrawals during retirement, something not available for traditional IRAs or even a 401(k). Additionally, early withdrawals from an IRA are much easier than from a 401(k), where withdrawals before the age of 59.5 are taxed and there’s a 10% penalty on the amount withdrawn.
However, there are a few exceptions to this case. Roth IRAs offer the ease of withdrawing money at any time without having to face penalties or taxes, except for investment earnings. In comparison, early withdrawal is a little difficult in traditional IRAs, where penalty-free withdrawals are allowed only in certain cases like buying a new house for the first time, medical and education expenses, etc. And, unlike a 401(k) or traditional IRA, Roth IRAs do not involve required minimum distributions (RMDs) after the age of 70.5.
Which One Should You Choose?
If income allows, an individual can invest in both these retirement instruments to obtain maximum benefits. Even if an employer match is not available, a 401(k) plan remains lucrative because of the significantly higher contributions that it allows compared to an IRA. However, with an IRA, individuals can choose from a wide variety of investment options and enjoy numerous flexibilities.
A Simple Way to Build Wealth
No matter what your financial goals are, investing in quality stocks is an option worth considering. Stocks have produced better returns than other kinds of investments over the years and generated significant wealth for shareholders. If you're interested in stocks but you're nervous about picking the right ones, Zacks can help. Our research team makes it simple to find long-term buys with long-term wealth-building potential. Starting today, you can see our private selection of stocks priced under $10, Warren Buffett-style value picks, dividend stocks and more. Click here for your sneak peak >>