It's time to invest, but you're not sure what type of retirement account is right for you. Perhaps you've heard your employer talk about a 401(k), but have also heard about something called an IRA. The 401(k) vs. IRA – what's the difference?
Let's define each term to help you figure out what's the best investment for you.
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The IRA (Individual Retirement Arrangement)
An Individual Retirement Arrangement is a form of retirement plan that gives investors (like you) certain tax advantages for retirement savings. Note that IRAs are also called “Individual Retirement Accounts,” but the term “Arrangement” is more appropriate.
Here are two of the most popular types of IRAs:
1. The Traditional IRA
When people refer to their IRA, they're typically talking about a traditional IRA. The great thing about a Traditional IRA is that contributions are tax-deductible, meaning you won't pay any taxes on your contributions. This is a great option if you desperately need the money you would normally pay in taxes for other types of contributions. However, you do have to pay taxes on withdrawals at retirement.
2. The Roth IRA
Contributions made into a Roth IRA are already taxed, but you won't have to pay taxes on withdrawals at retirement. This offers a mathematical advantage over the Traditional IRA, as your money grows tax-free! This type of IRA is highly recommended.
There are a number of other IRAs available but are seldom discussed. Here are a few of them:
- SEP IRA – For small businesses to contribute funds into their employee's Traditional IRA.
- SIMPLE IRA – This type of IRA requires the employer to match contributions to the plan whenever an employee makes a contribution. This is actually remarkably similar to the 401(k), but it does have lower contribution limits.
- Self-Directed IRA – Allows account holders to make investments toward the retirement plan.
For more information on funding an IRA and more, see Publication 590 produced by the IRS.
Like the IRA, a 401(k) is also a type of retirement savings account. Within the 401(k) can be a number of different investments, such as stocks, bonds, or mutual funds.
There are different types of 401(k)s just like the IRA:
1. The Traditional 401(k)
One major difference between the 401(k) and most other IRAs is the fact that employers are to match a certain amount of the contribution their employees make into the account. Businesses offer 401(k)s at their discretion for the benefit of their employees.
Traditional 401(k)s allow you to make tax-deductible contributions, but you'll have to pay taxes on withdrawals at retirement.
2. The Roth 401(k)
This type of 401(k) is very exciting. Here are a few facts about the Roth 401(k):
- You pay taxes on your contributions, but your investments grow tax-free and you can withdraw funds at retirement without paying any more taxes! This has a huge mathematical advantage, just like the Roth IRA.
- You still get a contributing match from your employer (like the traditional 401(k)).
Some businesses (such as corporations) are now offering the Roth 401(k), and if your employer offers it, by all means take it!
Another nice aspect of the 401(k) is that at this time it allows a higher rate of contribution. See 401(k) contribution rates for more information.
You may also want to read general information on 401(k)s from the IRS.
A Recommended Investing Strategy
Overwhelmed yet? There is a lot to learn when it comes to the 401(k) vs. the IRA. To make things a bit simpler, here is a recommended strategy for investing and making the most of your 401(k) and IRA.
The below investments are prioritized by their ability to build wealth:
- The Roth 401(k).
- The “Traditional” 401(k).
- The Roth IRA.
- The Traditional IRA.
Why would you choose this investment strategy? The 401(k) gives you the advantage of the employer match, while the “Roth” gives you the advantage of not paying taxes on your withdrawals.
Hopefully this information has helped you understand the differences between an IRA versus 401(k). Now go invest!
If you have any questions or advice for our readers on how you might invest in an IRA vs. a 401(k), leave a comment below!