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What Is a 401(k)?
A 401(k) is a tax-advantaged retirement savings plan offered by many employers. Employees can choose to have a portion of their paycheck automatically directed into their 401(k) account, reducing their taxable income. The money grows tax-deferred, meaning you won’t pay taxes on it until you withdraw it during retirement.
Employer Matching
Many employers offer to match a portion of your 401(k) contributions, which can significantly boost your retirement savings. For example, if your employer matches 100% of your contributions up to 3% of your salary, and you earn $60,000 a year, contributing 3% ($1,800) will result in an additional $1,800 from your employer, doubling your contribution to $3,600.
Vesting
Vesting rules determine when you fully own your employer’s matching contributions. Some plans vest immediately, while others may require you to stay with the company for several years before you fully own the matching funds.
Contribution Limits
For 2023, you can contribute up to $22,500 to a 401(k) plan. If you’re 50 or older, you can contribute an additional $7,500, bringing the total to $30,000. These limits do not include employer matching contributions.
Early Withdrawals
You can start withdrawing from your 401(k) at age 59½. Early withdrawals may incur a 10% penalty in addition to regular income taxes, unless exceptions apply.
What Is an IRA?
An Individual Retirement Account (IRA) is a retirement savings account that you can open independently of your employer. IRAs are available from banks, credit unions, brokerages, and mutual fund companies.
Types of IRAs
There are several types of IRAs, each with its own benefits:
- Traditional IRAs: Contributions are tax-deductible, but withdrawals in retirement are taxed.
- Roth IRAs: Contributions are made with after-tax dollars, but withdrawals in retirement are tax-free.
- Spousal IRAs: Allow non-working spouses to contribute to their retirement savings.
- Rollover IRAs: Used to roll over funds from other retirement accounts.
- SEP IRAs: For small business owners to contribute to their employees’ and their own retirement savings.
- SIMPLE IRAs: Allow both employer and employee contributions, similar to a 401(k).
Contribution Limits
For 2023, the contribution limit for IRAs is $6,500, with an additional $1,000 catch-up contribution for those aged 50 or older. Your contributions cannot exceed your income.
Early Withdrawals
Withdrawing from a traditional IRA before age 59½ incurs a 10% penalty and regular income taxes, unless exceptions apply. Roth IRA contributions can be withdrawn at any time without penalty, but earnings withdrawn early may incur a 10% penalty and income taxes.
Key Differences Between IRAs and 401(k)s
| Feature | 401(k) | IRA |
|---|---|---|
| Eligibility | Employer-based | Available to anyone with taxable compensation |
| Contribution Limits | $22,500 ($30,000 if 50+) | $6,500 ($7,500 if 50+) |
| Employer Matching | Possible | Not applicable |
| Portability | Can roll over to new employer’s 401(k) or IRA | Funds stay in your account |
| Vesting | May require a vesting period | Not subject to vesting |
| Early Withdrawal Rules | 10% penalty before 59½ | 10% penalty before 59½ |
| Loans | Possible | Not allowed |
| Required Minimum Distributions | Starting at age 73 | Starting at age 73 (Traditional IRA) |
| Roth Option | Some employers offer Roth 401(k)s | Roth IRAs available |
How to Choose Between an IRA and a 401(k)
Both 401(k) plans and IRAs offer significant tax advantages and are essential tools for retirement savings. Here are some considerations to help you decide which is best for you:
When to Choose a 401(k)
If your employer offers a 401(k) plan, it’s worth considering. Automatic paycheck deductions make it easy to save, and employer matching can provide an immediate return on your investment. Higher contribution limits also allow you to save more.
When to Choose an IRA
An IRA is a great option if you don’t have access to a 401(k) plan, such as if you’re self-employed or a non-working spouse. IRAs are easy to open and can be established at most financial institutions. They are also a good choice if you have a lump sum to invest.
Why Not Choose Both?
If you have the financial means, consider contributing to both a 401(k) and an IRA. This allows you to maximize your tax-advantaged savings. However, keep in mind that managing multiple accounts requires more effort.
The Bottom Line
Saving for retirement is a long-term commitment. Utilizing tax-advantaged accounts like 401(k)s and IRAs can help you build your retirement savings over time. Participating in your employer’s 401(k) plan and opening an IRA can provide additional opportunities to save and reduce your tax burden. Both types of accounts can help you achieve your retirement goals.
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