So you’re planning for retirement — and feeling unsure about which product is the best vehicle to get you there. These days, few people have access to “defined benefit” plans like the pensions that may have guaranteed your grandparents a certain payout from retirement through the rest of their lives. Instead, most retirement plans are of the “defined contribution” variety, meaning you (and maybe your employer) contribute a certain amount each month, quarter, or year, but the payout you’ll receive during retirement will be based on the market value of the account.
IRAs and 401(k)s are among the most common defined contribution plans, and both offer tax-advantaged retirement savings. However, there are a few key differences between these types of plans. The good news is that you don’t have to choose one over the other. If you’re planning well for retirement, it’s quite likely that your plan may include both a well-funded IRA and a 401(k). But it’s a good idea to be informed about the differences so you can make smart choices for your future.
What’s a 401(k)?
A 401(k), as well as a 403(b) and 457, is a qualified employer-sponsored retirement plan. If your employer does not offer a 401(k) or other sponsored plan, you should probably just begin saving in a Roth IRA or traditional IRA. But if you have access to an employer plan — especially if the employer offers matching contributions — that’s the best place to start.
Many employers offer a matching contribution up to a certain percentage of your salary. For instance, if your employer will match your 401(k) contributions up to 6 percent of your salary, you should always contribute at least 6 percent. If not, you’re turning down free money.
All the money you contribute to your 401(k) account is pre-tax money, meaning you will not be taxed on that money during the year you earned it. You will pay taxes on it when you withdraw it during retirement. During 2015, employees are allowed to contribute up to $18,000 of pre-tax income to a 401(k), and those over 50 can contribute an additional catch-up contribution of $6,000.
What’s an IRA?
While the opportunity to contribute to a 401(k) is limited to people employed by companies that offer such plans, anyone can contribute to a traditional IRA (individual retirement account), as long as they are under the age of 70½. Like a 401(k), an IRA offers tax-deferred growth on your investments, meaning the assets in the IRA will not be taxed until they are withdrawn. A traditional IRA may also offer tax-deductible contributions for people who don’t participate in an employer-sponsored plan.
A Roth IRA offers opposite tax advantages from a traditional IRA: You pay tax on income before you make contributions to the Roth IRA, but you’ll pay no tax on the earnings when you make withdrawals in retirement. However, not everyone qualifies for a Roth IRA. To qualify, you must have an adjusted gross income that is less than $116,000, or $183,000 for married couples filing jointly.
The limit for annual contributions to an IRA is $5,500 for 2015, and $6,500 for people over 50. That limit is the same for both traditional and Roth IRAs.