Saving for retirement isn’t as easy as simply opening an account – you need to know the difference between 401k and IRA, and between traditional and Roth IRAs if you want to maximize your retirement savings. These retirement savings plans share certain similarities, but there are significant differences that could cost you thousands if you make the wrong choice. Here’s a quick primer on 401k, IRA, and Roth IRAs to help you make an informed decision on which is the best vehicle for your retirement savings.
What is the difference between 401k and IRA?
401k and IRA are both tax-advantaged retirement savings vehicles, but a 401k must be employer-sponsored while an IRA or Individual Retirement Account can be offered by an employer or established by an individual. Only 60% of small businesses and 80% of larger companies offer an employer-sponsored retirement savings plan, according to a recent study. If you are fortunate enough to work for a company that offers a 401k retirement plan, you can open an IRA even if you are participating in your 401k. Some employers offer a Roth 401(k) The main differences between the 401k and IRA include:
- Contribution limits- are much higher for a 401k. Starting in the 2019 tax year, the 401k limit is $19,000 if you are under age 50, $25,000 for anyone age 50 and above. IRA and Roth IRA limits are $6,000 under age 50, $7,000 age 50 and above (all limits for 2018 were $500 lower).
- Investment options- With a 401k you are limited to the funds your employer offers. IRAs offer a much wider investment selection, because they are self-directed savings plans where the investment choice is up to you.
Is it better to have a 401k or IRA?
Whether it is better to have a 401k or an IRA depends on whether your employer offers a company match. If your employer offers a contribution match, you should fund your 401k up to the contribution level. That’s free money you don’t want to pass up!
Once you invest enough in your 401k to qualify for the full amount of matching funds, invest in an IRA until you max out your contribution, then go back to contributing to your 401(k). If your employer doesn’t offer matching funds, contribute to an IRA until you reach your limit before funding your 401k.
What is the difference between IRA and Roth IRA?
Traditional and Roth IRAs have the same contribution limits and yearly deadline, and both grow your money tax-free. The main difference between IRA and Roth IRA is when you pay taxes. Traditional IRAs are tax-deferred, meaning that you don’t pay taxes on them when you invest them. Contributions are tax-deductible and you are only taxed when you withdraw the money. With Roth IRA you pay taxes up front, so you receive the full amount of your qualified distributions when you start withdrawing funds.
Other differences with a Roth:
- With traditional IRAs, you must take distributions after age 70 but there is no required minimum distribution (RMD) with a Roth. You can even use a Roth IRA to pass money to your heirs.
- You can contribute to a Roth IRA at any age, while the cut-off for a traditional IRA is 70 ½.
- Almost anyone with earned income can contribute to an IRA, but there are income limits for Roth IRAs.
- Early withdrawal rules are much more flexible with Roth IRAs.
Credit: Inside Your IRA
Which type of IRA offers the best tax savings?
Whether a traditional IRA or a Roth IRA is a better choice depends on when you need tax savings the most. Do you want to enjoy tax-free withdrawals in the future or take advantage of the tax benefits now? Here’s an easy way to figure out which IRA type offers the best tax savings for your financial situation:
- If you are on a career path where you expect to be in a higher tax bracket when you retire, a Roth IRA offers the best tax savings because it allows you to pay taxes now while your rate will be lower. You'll be able to withdraw funds in retirement without incurring a higher tax bill.
- A traditional IRA is a better choice if you expect to be in a lower tax bracket in retirement or need to reduce your taxable income now. You may realize greater tax savings if it places you in a lower tax bracket now while you are still earning.
If you would like help choosing the best retirement savings vehicle to maximize your savings,
Matt Logan Inc. is an independent firm with Securities offered through Summit Brokerage Services, Inc., Member FINRA, SIPC. Advisory services offered through Summit Financial Group Inc., a Registered Investment Advisor. Summit Brokerage Services, Inc., its affiliates and Matt Logan Inc. do not give tax or legal advice. You should consult an experienced professional regarding the tax consequences of a specific transaction. These are the views of Matt Logan Inc, and not necessarily those of Summit Brokerage Services, Inc. and any of its affiliates and should not be construed as investment advice.