Planning for your future after you stop working often means utilizing tax-advantaged retirement plans. The Internal Revenue Service (IRS) recognizes several types of retirement accounts as tax-advantaged accounts. That means there are tax benefits to investing in them. Two of the most common are the IRA and the 401(k).
These retirement accounts allow you to invest in them now to keep the money in the account until you are ready to retire. To qualify for the tax advantages, it is critical to maintain these accounts long-term, as that gives the account time to build value. Which one is right for you? To find out, consider 401k vs IRA terms and conditions. Both 401(k) and IRA accounts have their place in providing a way to reduce tax obligations while allowing you to save for retirement.
What is an IRA?
An Individual Retirement Account (IRA) is one of the most common types of tax-advantaged retirement accounts. These accounts are ideal for those who do not have an employer-sponsored retirement account. There are two forms of IRAs. The traditional IRA allows you to contribute pre-tax dollars into your retirement account. As a result, it helps to reduce your taxable income in the year you are investing the money. Instead, you pay taxes on those funds when you withdraw them later in life.
A Roth IRA allows you to contribute income after it’s been taxed. That means you do not see any immediate tax reduction in the year you deposit the funds. However, you do not pay taxes on the money when you pull it out to use it during retirement, and you do not pay taxes even on the amount you earned on the investment.
IRAs come with income limits. To qualify for an IRA, you must make under the IRS eligibility limit for the year, which is based on your modified adjusted gross income (MAGI) on your tax account. For a traditional IRA, there is no limit to how much you can make per year. However, if you open a Roth IRA as a single tax filer, your MAGI must be under $161,000 for tax year 2024. If you are married and filing jointly, this increases to $240,000.
If you open an IRA, there is an annual contribution limit of up to $7,000 each year. If you are 50 or older, you can also contribute an additional $1,000 as a catch-up contribution. This applies to both traditional and Roth IRAs.
A final important component of IRAs is what happens when you’re ready to withdraw funds from them. With a traditional IRA, you cannot withdraw funds before the age of 59½ . If you do, you’re likely to pay a 10% penalty on the funds along with the applicable taxes. You must begin taking the required minimum distributions by the age of 73.
By contrast, you take contributions out of your Roth IRA at any time without having to pay penalties or tax on it. You also do not have to take withdrawals from your Roth IRA like you do from a traditional IRA.
What is a 401(k)?
A 401(k) is a tax-advantaged retirement account sponsored by an employer. Your employer typically establishes this type of retirement account and may or may not help contribute to it. Typically, if you sign up for the 401(k) with your employer, a percentage of your paycheck is put directly into the account. Some employers will match that amount or match a portion of the funds, helping you to build your account’s balance faster.
Typically, these accounts allow you to choose from various underlying investment options. You can allocate funds to various types of investments as a way to manage your risk tolerance.
Traditional 401(k) use gross income, or the money that comes from your paycheck prior to income tax deductions. That means you are not paying taxes on this money when it is going into the account but will pay taxes on it when you begin to withdraw the funds. This helps to reduce your taxable income for the year.
Roth 401(k) accounts are an alternative form that uses after-tax income to build the value. You pay taxes now, contribute the money, and do not pay taxes when you withdraw the funds later.
Like IRAs, there are some stipulations on these accounts. You can contribute as much as $23,000 per year if you are under the age of 50 or up to $69,000 per year if you are 50 or over for 2024.
If you try to withdraw funds from your account prior to reaching the age of 59 ½ years old, you will pay taxes on those funds along with a penalty of up to 10%. This applies to all 401(k) owners. Those with a traditional 401(k) will need to make the required minimum distributions by the time they reach the age of 73.
To build value, these retirement accounts use your money to invest in underlying securities. Those investments are managed by a financial advisor that oversees all investment contributions. The investment types range widely but tend to include S&P 500 index funds, US Treasury bonds, and a wide range of other investments.
IRA Key Features
IRA and Roth IRA accounts are ideal for those who do not have an employer who is offering a retirement account.
Key features of the traditional IRA include:
- Contributions are with pre-tax dollars. The money grows in your account over time.
- You pay taxes on them when you withdraw the funds in retirement. Typically, a person’s retirement tax bracket is lower than their tax bracket during their working years.
Key features of the Roth IRA include:
- Contributions are made with after-tax dollars. The money grows in the account over time.
- You do not pay taxes on any of the withdrawals you make, making this a better option for those who expect to be in a higher tax bracket later in life.
401(k) Key Features
Both 401(k) options offer similar features in that they are both employer-sponsored. They are also typically managed by financial advisors.
Key features of a traditional 401(k) include:
- Contributes are made with pre-tax dollars. The money is automatically put into the account.
- Employers may match some or all of the contributions you make.
- You pay taxes on the funds in retirement when you begin to withdraw them.
Key features of a Roth 401(k) include:
- Contributions are made after you’ve paid taxes on the funds.
- The money grows based on the investment decisions you make that are managed by the investment firm.
- When you make withdrawals, you do not pay any taxes on the contributions you made or on the earnings.
IRA vs 401k: Contributions and Matching
Let’s take a look at how these types of investments compare the difference between IRA and 401(k) accounts. You can compare both forms to each other to get a better idea of which may be better for your situation.
Employee Contributions
IRAs have caps on the amount of money you can invest each year. For 2024, that amount is $7,000 for those under 50 and an added $1,000 for those over the age of 50.
401(k)s allow you and your employer to contribute significantly more at $23,000 for those under 50 and $69,000 for those over the age of 50.
Employer Matching Contributions
The key benefit to the 401(k) is that your employer can contribute to your account. That’s not an option with an IRA. Employers can match a percentage or the full amount you contribute, increasing your retirement savings growth.
Withdrawals and Tax Considerations
Once your money is in your account, it begins to grow at a rate dependent on the underlying investments. What happens when you’re ready to withdraw the funds?
Withdrawals from IRAs
You can withdraw money from your traditional IRA after the age of 59 ½ years old. If you do so before that point, you will pay a 10% penalty and taxes on the funds.
The Roth IRA does not have any penalties for early withdrawal of the contribution portion. That’s because you’ve already paid taxes on those funds. You can begin to take money out of this account at any time.
Withdrawals from 401(k)s
401(k) funds can also be withdrawn when you reach 59 ½ years of age. Any withdrawals before that period means you’ll pay a 10% penalty and taxes on the funds.
However, it is possible to borrow money from your 401(k) account. This is a loan, and you will pay fees and interest on the amount you borrow. When you need to access the money in your account, this is one avenue to consider.
Key Difference Between 401k and IRA
Both IRA and 401(k) are retirement accounts but here are some key differences between the two.
Contribution Limits
Both 401(k) and IRAs allow you to contribute either pre- or after-tax money to your account. However, the annual contribution limit is higher for a 401(k) than an IRA account. This could mean that you are able to save more through an employer-sponsored plan.
Tax Treatment
The key tax treatment isn’t so much about whether you choose an IRA or a 401(k) but rather the account type you select.
- With a traditional IRA or 401(k) account, you can get a tax deduction in the year that you make the contribution. This can lower your taxable income for the year. In other words, your traditional account contributions are tax deductible but you pay taxes on both the contributions and any earnings when you withdraw in retirement. That being said, be aware that high income earners would not be able to deduct contributions to both 401(k) and IRA. Refer to the IRS Deduction Limits for traditional IRAs for more information.
- With a Roth IRA or 401(k), you would make after-tax contributions – meaning you would pay taxes on the contribution in the year that it’s made. Thus, your investments grow tax-free without any additional taxes levied when it comes time for withdrawals.
Employer Involvement
Employer contributions can be added directly to your 401(k), and that could potentially increase your earnings. If your employer offers a contribution to a retirement account, they are giving you added income each year.
Choosing Between an IRA and 401(k)
Which of these is better for your situation? While speaking to a financial advisor is typically the right first step, consider a few tips.
Factors to Consider
- Does your employer offer a 401(k) account?
- If the employer is offering a retirement plan, will they be offering contributions through an employer match? If so, how much?
- Who will pay for the management of the underlying investments?
- What type of control do you have over the investments in either option?
- Do you expect to have a higher income during retirement or now?
When to Choose an IRA
If you don’t have access to an employer-sponsored retirement account, an IRA is an option. It is available to anyone through a variety of financial institutions. They are ideal for those who want to reduce their taxes while saving for retirement.
When to Choose a 401(k)
If your employer offers a 401(k), especially if they offer to match your contributions, using this account tends to be wise. More so, if you are a high-income wage earner, you also will want to take advantage of this opportunity to contribute more to your retirement account.
Why Not Choose Both?
An alternative option is to use both. You can open your own IRA account and contribute to it even if you have one with your employer. This allows you to tap into diversified retirement planning, allowing you to contribute more and potentially reduce your taxes further.
More so, when you contribute to both accounts, you may gain access to a wider range of investment options. That could mean more flexibility to invest in companies, stocks, bonds, and other methods that are more in line with your objectives and goals.
You can contribute to both, but you must stay within the contribution limits of both account types, as noted above.
Final Thoughts
The investment in any type of retirement planning is wise, and both of these types of tax-advantaged plans are often worthwhile. Often, the first and main consideration is the availability of an employer-sponsored plan with a matching contribution. However, even if you have a 401(k), opening both accounts can prove to be an excellent way to benefit from both forms of retirement planning.
Your financial situation is unique. Make sure you consider your long-term savings goals in making these decisions.
Explore HFS FCU’s Comprehensive IRA Options
HFS Federal Credit Union offers the help and support you need. If you are looking for an easy-to-manage way to boost your retirement savings, set up an IRA with us today. Consult with an HFS FCU financial advisor for a personalized retirement consultation to discuss your options.
Frequently Asked Questions (FAQs)
What are the main differences between a Traditional IRA and a Roth IRA?
The traditional IRA utilizes pre-tax dollars for investment, while the Roth IRA offers after-tax dollars. That means that you’ll pay taxes on withdrawals in retirement for traditional IRAs but not for Roth IRAs.
Can I contribute to both a 401(k) and an IRA in the same year?
Yes, you can. Make sure you stay under the required contribution limits for each type to minimize penalties.
How does the employer matching contribution work in a 401(k) plan?
Your employer makes the decision on whether they wish to contribute to your retirement plan and the percentage that they want to contribute. This could be up to 100%.
Are there any age restrictions for contributing to an IRA or a 401(k)?
No, you can contribute to IRAs and 401(k) at any age. The IRS does not set age restrictions on these accounts.
What are the penalties for early withdrawal from a 401(k) or an IRA?
If you have a traditional IRA or 401(k), and you withdraw the money from the account prior to reaching 59 ½ years of age, you will have to pay taxes on that amount at the time at your current tax bracket. Additionally, a 10% penalty is also applied.
How do RMDs (Required Minimum Distributions) differ between IRAs and 401(k)s?
If you have a Roth IRA or 401(k), you do not have to make the required minimum distributions. That means the money can stay in these accounts long term. However, if you have a traditional IRA or 401(k), you must begin to withdraw funds from your account by the time you reach the age of 73.
Can I roll over my 401(k) into an IRA? If so, what are the steps and considerations?
It’s possible to roll money over from a 401(k) to an IRA, especially if you are no longer working with that employer. You’ll work directly with the administrator of the retirement account to set up and transfer the funds. It’s best to ensure this is done electronically and automatically for you so you don’t face any penalties.
