Should you have a traditional 401(k), an IRA, or both?

If you want to retire, you’ll need savings. Choosing the right retirement savings plan can feel like a lot of pressure – after all, it’s a key part of your future. If you’re not sure whether to go with a 401k, an IRA, or both, you’re not alone. Fortunately, all options provide great tax benefits. Keep reading to figure out which one’s right for you.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement savings plan. When an employee signs up for a 401(k), they specify a percentage of each paycheck to go directly into their investment account. 401(k) plans are typically tax-deferred, meaning you don’t pay taxes on the money you add to the account. However, you will be taxed once you withdraw the money from your 401(k). The amount you’ll be taxed depends on the type of 401(k) you choose.

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Sometimes, employers offer 401(k) matching, meaning your employer will also contribute a percentage or dollar amount to your retirement. 401(k) matching can be either a partial match plan or a full match plan.

• In a partial match plan, the employer matches a smaller amount – for example, an employer may match 50 cents for every dollar the employee contributes to their 401(k). Partial match plans usually specify a cap for employer matching – for example, an employer may match up to 6% of your salary.
• Full 401(k) matching, also known as dollar-for-dollar matching, is when an employer matches the same amount of money that you put into your account. Again, there’s usually a cap for how much your employer will match. Not all companies offer 401(k)s, and not all employers offer 401(k) matching.

There are two main types of 401(k)s – traditional or “regular” 401(k)s and Roth 401(k)s. The type of 401(k) you choose will determine how you’re taxed.

Traditional 401(k)s

With a traditional 401(k), your contributions are pre-tax, meaning that you won’t be taxed at the time of contribution, but when you withdraw money from your 401(k) later.

Roth 401(k)s

With a Roth 401(k), you pay tax on the money you contribute to the account, and then when you withdraw money from the account, it will be tax-free. A Roth 401(k) is most beneficial when you are starting out your career or expect to be in a lower tax bracket for a while. This is because when you are earning less, your federal income tax is also lower. When you are eventually in a higher tax bracket and it’s time to withdraw the money, you won’t have to pay the higher taxes that come with a higher tax bracket because you already paid them when you added to the account.

What is an IRA?

IRA stands for Individual Retirement Account. IRAs allow individuals to set up and save for retirement through a financial institution, like their bank. If you’re a freelancer or contractor, or your employer doesn’t offer a 401(k), an IRA is a great retirement savings option for you. You can manually add money to your IRA, or you can schedule automatic transfers to your IRA each week or month through your checking or savings account.

There are two main types of IRAs: traditional IRAs and Roth IRAs.

Traditional IRA

Your contributions to a traditional IRA may be fully or partially tax-deductible. However, you’ll have to pay taxes once you withdraw money from the account.

Roth IRA

With a Roth IRA, the money you deposit into the account is already taxed, and you don’t pay taxes on withdrawals once you retire.

IRA vs 401(k): which should you choose?

IRAs and 401(k)s offer great tax benefits – you can use both to save for retirement. A 401(k) is a great choice if your employer offers 401(k) matching – IRAs don’t offer this money-growing feature. Another advantage to 401(k)s is that they offer higher contribution limits:

• In 2022, the contribution limit for a 401(k) was $20,500 or $27,000 for people aged 50 years or older
• • In 2022, the contribution limit for both Roth IRAs and traditional IRAs combined was $6,000, or $7,000 for those aged 50 or older.¹

On the other hand, IRAs typically offer better investment options for stocks, mutual funds, and more. And they have no minimum distributions. When you have money in your retirement accounts, it can’t stay there forever; minimum distributions are the minimum amount you are required to withdraw from your account each year once you turn 72. The IRS calculates your minimum distribution amount based on your age and the balance in your account.

If your employer provides 401(k) matching, and you can afford to, you should put enough money in your 401(k) to meet the maximum match amount for the year. Then, you can start adding money to an IRA. Once you meet the maximum contribution amount for your IRA, you can continue contributing to your 401(k).²

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