When planning for retirement, it can be confusing and there is a lot of information out there on what to do, what not to do and different advice on how to make your money last. We are sure you have seen the term "401k" and "IRA" and know they are both tied to your retirement but not too sure what they are and how they are different.
What is a 401k?
A 401k is a qualified employer-sponsored retirement plan. Many employers offer matching contributions up to a predetermined percentage of your salary, which typically depends on your role in the company. If you only take one thing away from this post, please make sure it is this..make sure you know what you company is matching on your 401k because if you do not take advantage of that program, you are essentially leaving FREE money on the table.
Here is an example for you:
Meet Kate, she does Marketing in the city and her company offers an 8% match on her 401k. Kate has determined it would make the most sense for her to contribute at least 8% as well, to maximize her company's match. Contributions to traditional 401ks are "Qualified" meaning they will not be taxed going in, but distributions will be taxed as ordinary income in retirement.
According to Hermoney.com:
During 2020, employees are allowed to contribute up to $19,500 of pretax income to a 401(k), and those over age 50 can contribute an additional catch-up contribution of $6,500."
An IRA is typically offered to anyone and everyone regardless of your employer. An IRA, similar to a 401k, offers tax deferred growth, which is when the money going in is pre-tax, but income taxes will apply to future distributions. An IRA may also offer tax deductible contributions as well, but this is not in every situation. There are two types of IRA's: Traditional and Roth.
A Roth IRA essentially offers opposite tax advantages than a traditional IRA. You contribute post-tax dollars you put money into the account, but when you take it out, it is not taxed as income. You may not be able to qualify for a Roth IRA though. To qualify, you need an adjusted gross income that is less than $124,000, or $196,000 for married couples filing jointly.
So what is the difference?
Both a 401k and IRA offer tax advantaged retirement savings. A constant between the two (other than the Roth IRA) is the fact that the money you are contributing is pre-tax but will be taxed when you withdraw these funds.
The nice thing is you don't have to choose between one or the other. It is completely okay and even may be a best practice to have multiple future income streams for your retirement plan. You should always consult a professional in regards to your retirement plan to make sure you are maximizing you plan in all the right areas while mitigating any tax implications.
Source: Her Money, "IRA vs 401(k) - What's the Difference?
For Educational Purposes Only – Not to be relied upon as financial, tax, or legal advice. The views expressed are those of the author/presenter and all data is derived from sources believed to be reliable.
Illustrations are hypothetical. Consult a qualified professional regarding your individual circumstances.