Planning for Retirement: 401(K) VS. IRA
If you are a devoted follower of personal finance shows, then you probably have spent a little time watching wildly popular Mad Money hosted by Jim Cramer. The show focuses on helping investors enrich their lives financially, especially when it comes to saving for retirement. However, the amount of information presented about retirement plans can be a bit overwhelming.
Let’s take a look at the two most popular retirement plans by comparing an IRA with a 401(k).
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Overview of Retirement Plans
You do not need a financial advisor to tell you that saving for retirement is one of the most important personal finance decisions you will ever make. The financial world for retirees has dramatically changed, with defined benefit pension plans becoming a dinosaur and Social Security leaving much to be desired for providing financial security.
The result has been a mass transformation on how Americans plan for retirement. Instead of relying on the retirement benefits handed out by a company and the federal government, a rapidly growing number of professionals are taking financial matters into their own hands by establishing sound retirement plans.
Starting and managing a retirement plan requires considerable financial discipline, as well as understanding everything you need to know about a 401(k) vs. an IRA.A Review of 401(k) vs. IRA
A 401(k) and an IRA offer many of the same tax and savings benefits. However, each type of retirement plan comes with a unique set of rules that dictates for most Americans which type of retirement plan is the best fit for socking away the most money.
The main difference between the two most popular retirement plans is that a 401(k) is established by your employer, while you have complete control over the management of an IRA. In addition, employers decide how much to match for employee contributions to a 401(k) plan. Employers that want to offer employees a tax-friendly way to save money for retirement also have the option to create a Simplified Employee Pension (SEP) plan or a Savings Incentive Match Plan for Employees (SIMPLE).
On the other hand, an IRA represents an individual retirement plan tied directly to the decisions made by you. You can opt to contribute a percentage of your income to an IRA, as well as finance an IRA by rolling over the balance generated by an employer-sponsored retirement plan, such as a 401(k).
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What You Need to Know about a 401(k)
We are always looking for ways to lower our tax bills. One of the most effective tax-lowering strategies involves putting income away in a tax-deferred 401(k) retirement account. The employer-sponsored plan allows employees to contribute a pre-determined amount of money from each paycheck into a retirement account. Your employer can match your contributions to a 401(k). Contributions to 401(k) plans are made pre-tax, which means you lower the gross income used to calculate what you owe in state and federal income taxes.
The amount of money earned from investment income within a 401(k) plan compounds tax-free until you decide to take out money from a 401(k), which you can do once your turn 59 1/2 years old. Withdrawals from a 401(k) plan are taxed at the normal rate mandated by state and federal income tax laws. However, your income tax rate at retirement will be much lower than what it was during your peak earning years.
As with most laws pertaining to personal finance issues, the rules for contributing to a 401(k) have changed for 2020. You can contribute as much as $19,500 to a traditional 401(k) retirement plan, with professionals older than 50 years granted the capability to play catch up by contributing $6,500 more than the maximum $19,500 contribution allowed by law. You might be eligible to take out a hardship loan from a 401(k) plan. Moreover, your employer will limit your investment options to a few choices, which means you might not be able to take advantage of a historic stock market boom.
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What You Need to Know about an IRA
Although there are a number of different IRA plans, for this discussion, we will refer to a traditional IRA. An IRA represents a tax-deferred type of retirement savings plan that is managed solely by you. You make the investment decisions by opening an IRA through virtually any type of financial institution like a bank, insurance firm, or an investment company
As opposed to a 401(k) retirement plan, An IRA typically does not include a provision that permits you to take out a hardship loan, However, you have many more investment options than the investment options offered by a 401(k). This means you can diversify your retirement funds by investing money in stocks, bonds, Certificates of Deposit (CDs), and even into real estate driven mutual funds.
The primary similarity between an IRA and a 401(k) is the tax deduction benefit. The earnings generated by investment income within an IRA grow tax-free until you start paying taxes on the withdrawals made after retirement. Annual contribution limits for an IRA are more restrictive than the contribution limits associated with a 401(k). As of 2020, the maximum amount of money you can contribute to a traditional IRA is $6,000, with federal law allowing anyone over 50 years old to play financial catch up by contributing $1,000 more than the $6,000 maximum contribution limit.
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How to Make a 401(k) and an IRA Work for You
You probably want to know how much of your income you should put away in a retirement plan. When it comes to retirement saving, the answer is not about deciding between a 401(k) or an IRA. In fact, you can make both types of retirement savings plans work for you.
If you qualify to invest in both a 401(k) and an IRA, the first thing to do is enroll in your company’s 401(k) plan. You should contribute at least what your employer has decided to match to maximize the compounding benefit of interest on the investments made in a 401(k). Then, open an IRA and contribute the maximum amount of money granted by federal law. Now, revisit the contributions made to your employer’s 401(k) plan and decide if you can afford to increase your annual contributions.
Opening both types of retirement plans gives you optimal investment flexibility.
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The Bottom Line
As you see, investing in a retirement plan is an effective strategy for investing in yourself. Instead of making retirement savings an either/or debate, why not maximize the benefits of saving money for retirement by investing in both a 401(k) plan offered by your employer and an IRA that you have complete control over by making the investment decisions.
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