Saving for retirement is essential, and starting as soon as possible helps you take advantage of compounding interest. However, it can also be a daunting task, especially if you aren’t sure what types of retirement accounts are available and which option(s) are best for your needs. Two of the most common account types are 401(k) plans (often written as 401k plans) and Individual Retirement Accounts (IRAs).
Defining 401k Plans and IRAs
A 401k is a type of retirement plan offered through an employer. Employees contribute a percentage of their income directly from each paycheck. Contributions can be made pre-tax with a traditional 401k or after-tax with a Roth 401k. Many employers match 401k contributions, typically based on a percentage of the employee’s contributions.
An IRA is separate from an employer. It is a tax-advantaged personal savings plan that an individual can set up with a bank, financial institution, life insurance company, mutual fund, or stockbroker. Like 401k plans, you can choose a traditional IRA, Roth IRA, or a combination of both.
Which Plan(s) Should You Contribute To?
If your employer doesn’t offer a 401k, then an IRA allows you to save for your retirement on your own. In this situation, the decision of which plan to use has already been made for you. However, if you do have an employer-sponsored plan, you may be wondering whether you should be contributing to an IRA in addition to or even instead of a 401k.
In most cases, you don’t need to choose only one account to contribute to. 401k plans and IRAs are both tools in your savings kit, and you can use each in a way that best fits your personal situation and goals.
The factors below can be helpful as a starting point for understanding the differences between these account types.
Matching
One of the primary benefits of a 401k plan is the potential for an employer match. A match helps you grow your money more effectively and in most circumstances, it makes sense to take advantage of this.
Hassle Of Transferring
Since 401k plans are tied to an employer, there are considerations to keep in mind if you leave your job. You’ll likely need to transfer the 401k funds, either to a new employer-sponsored 401k or to an IRA. Some employers do allow you to keep the funds in an existing 401k, but you will still be unable to contribute to it.
Investment Options
With 401k plans and IRAs, you’ll be able to choose from various options for how to invest the funds. These include mutual funds and exchange-traded funds (ETFs). With an IRA, you have additional options available and more flexibility for how you choose to invest.
Contribution Limits
The Internal Revenue Service (IRS) sets annual contribution limits for retirement savings accounts. The limit is significantly higher for 401k plans.
As of 2023, these limits are:
- 401k – $22,500 ($30,000 if you are over 50)
- IRA – $6,500 ($7,500 if you are over 50)
Borrowing Options
401k plans allow you to borrow money from the account, depending on the specific terms in your employer’s plan. This is not the case with IRAs.
Tax Benefits
Any contributions to a traditional 401k are tax-deductible. Conversely, only some traditional IRA contributions are tax-deductible. This will depend on your income and if you also have a 401k plan.
Get Personalized Help With Retirement Planning
Everyone’s financial situation is different, and there’s no one-size-fits-all solution for whether to contribute to a 401k, IRA, or both. In addition to the differences above, you should also consider your other savings goals, spending needs, and income. Working with a retirement planner can help simplify the process. One of our advisors at Wellspring can answer your questions and give you personalized advice for your unique situation.
Contact us today to learn more about our retirement planning services.
Wellspring Financial Partners, LLC does not provide tax or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
