When you’re young, it feels like retirement is so far away. And there are competing priorities for your money, like vacations, saving for a house, or buying a new car. It’s no surprise the Federal Reserve found that only 36% of adults think their retirement savings is on track.
Understanding how 401(k)s and IRAs work is essential. Each has an important place in your retirement saving strategy, and using them to their full potential can help you build your retirement nest egg.
What Is a Retirement Account & How Does It Work?
A retirement account is a financial account you designate to help you save money for retirement. Unlike standard savings accounts, they have benefits that encourage people to save for retirement more effectively, like restrictions to ensure they’re used only for that purpose. You can open one at a brokerage, bank, or other financial institution.
There are many different types of retirement accounts, including 401(k)s and individual retirement accounts (IRAs). Both have some unique features, though some basics hold true for all retirement accounts.
While you can open a CD or savings account in an IRA, most people have decades between the time they start saving and the time they retire. That makes investing the money a better plan for growing their savings.
Depending on whether you use a 401(k) or an IRA, you can invest in things like:
- Stocks: Shares in individual companies
- Bonds: Debt issued by state, federal, and local governments or businesses
- Mutual Funds: Baskets of stocks and bonds you can easily invest in by buying shares of a single fund
- Exchange-Traded Funds (ETFs): Mutual funds you can trade to other investors instead of buying and selling exclusively with the fund manager
- Options: Advanced securities investors use to speculate on whether a stock’s price will rise or fall
- Commodities: Everyday items like coal, oil, gas, or corn that people buy and sell on large scales
The majority of retirement investment happens in mutual funds and ETFs, especially when you’re using a 401(k). IRAs that you open through brokers like M1 Finance are more flexible, and some investors buy individual stocks and bonds in their IRAs. Most investors avoid more complicated and volatile investments, like options or commodities.
The government places limits on the amount of money you can put into a retirement account each year. These limits prevent high earners from receiving a significantly higher benefit from these accounts than lower-income workers. Some accounts limit you to $6,000 or less, while others let you contribute more than $50,000.
Incentives to Save
While saving money is important, it isn’t exactly fun. Most people would rather buy a new car or go on a trip than set their money aside for the future.
To encourage people to save, retirement accounts offer incentives when people use them. These often take the form of tax incentives, which can reduce the amount you’ll owe in taxes now or in the future.
Restrictions on Withdrawals
If you’re putting money into a retirement account, the idea is you’ll use that money for retirement. The government gives you tax incentives precisely because it wants to encourage retirement savings. It doesn’t want you raiding your retirement fund for a luxury vacation or second home, so it restricts your ability to make withdrawals from all types of retirement accounts.
Typically, the government makes you pay a penalty on money withdrawn before you reach a certain age unless you remove it for an approved reason, such as buying a first home or funding education. However, the approved reasons vary by account.
How 401(k)s Work
When most Americans think of retirement accounts, they think of a 401(k).
You can only get access to a 401(k) as an employee benefit through an employer, though solo 401(k)s are available for the self-employed through Rocket Dollar. If your employer doesn’t offer a 401(k), you can open an IRA instead.
Contributions & Limits
The only way to make contributions to your 401(k) is through payroll deductions. This is money taken from your paycheck and deposited into your 401(k). You can’t make additional deposits into the account. But you can tell your company, usually through your payroll system or the human resources department, how much money to take out of each paycheck as either a flat amount or a percentage.
There is an annual limit to the amount you can contribute to your 401(k). You can’t contribute more than the greater of:
- Your annual income from the employer
- $19,500 if you’re under the age of 50 or $25,500 if you’re 50 or older
Rarely, employers add other restrictions, such as limiting your contribution to 30% of your salary or less. However, sometimes, your payroll or HR department can override these restrictions upon request.
The age-related limits apply to all the 401(k)s you’re eligible for in total. So if you have multiple employers that offer 401(k)s, you can’t contribute the full amount to each.
And there are even more restrictions if you’re a highly compensated employee (HCE), meaning you make $120,000 or more per year from your employer or own at least 5% of the company employing you. HCEs can’t contribute more than 2% more than the average contribution of non-HCEs at the same company. So, if non-HCEs contribute an average of 5% of their pay to their 401(k)s, HCEs can contribute a maximum of 7% of their salary. If an HCE makes an excess contribution, 401(k) providers must return the excess.
This limit on HCE contributions only applies to companies that don’t offer a safe-harbor 401(k), which has specific employer matching requirements.
To entice new employees or help retain current staff, employers often offer to contribute to employees’ 401(k)s. Some employers match the employees’ contributions, while others make contributions whether the employee does or not.
When employers match an employees’ contributions, they usually base the match on how much the employee makes each year and how much the employee contributes to their 401(k).
For example, say an employee makes $50,000, and their employer offers a 100% match on the first 3% of the employee’s salary. For every dollar the employee contributes up to 3%, or $1,500, of their $50,000 salary, the employer contributes $1. If the employee chooses to contribute more than $1,500, the employer stops matching contributions.
A safe-harbor 401(k) meets one of three employee contribution-matching requirements set by the government:
- A 100% match on the first 3% of the employee’s compensation contributed plus a 50% match on the next 2% contributed
- A 100% match on the first 4% contributed
- Automatic contribution of 3% regardless of employee contribution
When an employer matches employee contributions to a 401(k), the employer retains ownership of that money until the employee vests in the plan. If the employee leaves the company before vesting, the employer takes their matching contributions back. Vesting gives employers a way to retain employees.
Some companies use a cliff vesting plan in which a worker goes immediately from being 0% vested in their plan to 100% vested when they reach a certain number of years of service. Others use a graded vesting plan, which allows them to vest their employees by a smaller percentage each year of service. For example, employees may be 20% vested after one year, 40% vested after two years, and so on until they’re 100% vested after six years of service.
If they leave their job, unvested employees lose any money the employer contributed. Once an employee vests in a plan, contributions made by their employer become theirs to keep, even if they leave their job.
Employers select the financial service companies that manage their 401(k) plans. They also choose the investment options available in their 401(k)s. Depending on the financial firm your employer works with, this can be highly limiting, as most plans don’t offer any way to go outside their offerings to invest in other providers’ mutual funds or individual securities.
The majority of 401(k) plans offer basic mutual funds and target-date retirement funds. For most people, these are fine choices, but they make it difficult for experienced investors to execute advanced strategies. For example, it can be challenging to hedge investments without the ability to trade options or individual securities.
Fees are also a significant drawback of this kind of closed system. Some financial companies charge massive fees if you want to invest in their mutual funds. If your employer’s 401(k) funds have high fees, you won’t have any choice but to pay them. In the long run, even nominal fees can have a massive impact on your investments.
For example, if you invest $400 per month every month for 40 years and earn 7% returns each year, you end up with a total of $964,238.32 in the account at the end of that 40 years. But if you had paid a 1% fee annually over that period, it would drop your returns to 6%, and your ending balance would become $746,971.72. A fee of just 1% can cost you more than $200,000 over the course of your career.
Pro tip: If you have a 401(k) or an IRA, make sure you sign up to receive a free portfolio analysis from Blooom. They will make sure you have the right allocation and are properly diversified based on your risk tolerance. Blooom will also analyze the fees on your account so you’re not paying more than you should each year.
When you contribute to a traditional 401(k) plan, you can deduct that amount from your income when you file your taxes, which means every dollar you save in your 401(k) costs less than a dollar out of your pocket.
Consider this example: A single person with an adjusted gross income (AGI) of $50,000 is in the 22% tax bracket. If they contributed $5,000 to a 401(k), that would reduce their AGI to $45,000, which is still in the 22% tax bracket. Because of the reduction in AGI, their tax bill would drop by $1,100. They’d have $5,000 in a retirement account at a cost of just $3,900 out of pocket.
You can only deduct the contributions you make to a 401(k). Employer contributions aren’t taxed, but they aren’t deductible either.
But 401(k)s aren’t entirely tax-free. You do have to pay taxes on the money you withdraw from the account. The idea is that your contributions during your working years happen when your income and tax rate are higher. So when you make withdrawals once you’re retired and making less, you’re in a lower tax bracket. If that is true, your overall lifetime taxes are lower if you contribute to a 401(k).
There are also Roth 401(k)s, which are rarer than traditional 401(k)s. With a Roth 401(k), you don’t get to deduct any contributions, but you don’t have to pay taxes on the money or its earnings when you make withdrawals during retirement. As a bonus, you can also withdraw your contributions – though not your earnings – from a Roth 401(k) at any time without penalty.
How IRAs Work
Anyone can open an individual retirement account because, unlike 401(k)s, they’re available independent of a specific employer. That gives you the freedom to choose the brokerage you want to work with. You can choose a more traditional broker like TD Ameritrade or a company like M1 Finance, which allows you to invest for free. IRAs also give you more flexibility when deciding what to invest in.
There are two types of IRAs to choose from: traditional IRAs and Roth IRAs. Each has its own benefits, drawbacks, and restrictions.
Contributions & Limits
Because your employer doesn’t manage your IRA, you can’t contribute with payroll deductions like you do for a 401(k). Instead, you must deposit money into the account like any other bank or brokerage account.
One major disadvantage of IRAs is that they have lower contribution limits than 401(k)s. The base limit for 2019 is $6,000. If you’re 50 or older, you can contribute an extra $1,000. If you make less than $6,000 in a year, you can only contribute up to your full income. On top of this restriction, there are income limits that reduce the benefit of using a traditional IRA. If you exceed the income limit, you can contribute, but you won’t get the tax benefits.
But these limits only apply if you or your spouse works for a company that offers a 401(k). The limit varies based on whether you contribute to a traditional or Roth IRA.
In 2019, if you’re single or filing as head of household, you can deduct the full amount of your contribution if you make less than $64,000 per year. If you make more than $64,000, you can only deduct a portion of your contribution, with the deductible portion shrinking as your income rises. Once you make $74,000 annually, traditional IRA contributions become nondeductible.
For people who are married and filing jointly, the deduction phase-out starts at $103,000 in annual income. If you and your spouse combined make more than $123,000 a year, you cannot deduct traditional IRA contributions. People married but filing separately can never deduct the full amount of their contribution and cannot take any deduction if their annual income exceeds $10,000.
Unlike traditional IRAs, Roth IRAs have hard income limits, after which you cannot contribute.
In 2019, if you’re single or filing as head of household, you can contribute up to the standard Roth IRA contribution limit s long as your annual income remains under $122,000. The contribution limit shrinks for every dollar over $122,000 earned. Once you earn $137,000 in a year, you can no longer contribute to a Roth IRA.
Married people who file jointly can make a full contribution to a Roth IRA if their combined annual income is less than $193,000. If their yearly income is $203,000 or more, they cannot contribute at all. People who are married filing separately cannot make a full contribution to a Roth IRA and can’t contribute at all if they make $10,000 or more in a year.
Greater flexibility makes IRAs more appealing than 401(k)s to many retirement investors. You can open an IRA with any financial institution that offers one, and you can use it to invest in almost anything. If you want to buy individual stocks, you can. You can trade options, futures, or commodities. IRAs can even hold real estate.
This flexibility means you can choose the mutual funds with the lowest fees or execute complicated trading strategies that rely on hedging or real estate investment. Advanced investors can get a lot of mileage out of their IRAs.
Both traditional and Roth IRAs help you save for retirement. But their tax benefits differ.
Traditional IRA Tax Deductions
A traditional IRA works like a traditional 401(k). You can deduct the amount you contribute from your taxable income when you file your tax return. This reduces your tax bill. In exchange, you pay taxes on money you withdraw in the future.
Roth IRA Tax Deductions
Roth IRAs work in reverse. You pay taxes as usual when you make contributions to a Roth IRA. However, when you make withdrawals from a Roth IRA, you pay no taxes on the money you withdraw, including any of the returns your investments earn.
This makes Roth IRAs an excellent choice for people whose income is low enough to put them in a lower tax bracket than they expect to be during retirement. They can save money by prepaying their taxes at a lower rate and making tax-free withdrawals when they would have paid a higher rate.
401(k) vs. IRA: Which One Should You Use?
You can use both 401(k)s and IRAs for retirement savings, and many people use both. But if you have to choose, make the most out of your retirement savings by selecting the option that’s best for you.
How to Choose Between a 401(k) & an IRA
If you only have enough money to contribute to one account or don’t want to deal with multiple accounts, there are several rules of thumb you can use when deciding between a 401(k) and IRA.
A 401(k) is a better option if:
- Your employer offers a 401(k) match
- The investment options in your 401(k) match your investment plan
- The 401(k) doesn’t charge high fees
An IRA is a better option if:
- You don’t have access to a 401(k) through your employer and don’t qualify for a solo 401(k)
- Your 401(k) charges high fees
- You want to use investments that aren’t available in your 401(k)
How to Prioritize Your IRA vs. Your 401(k)
For most people, the best way to save for retirement involves using both a 401(k) and an IRA. Properly prioritizing each account helps you make the most of your retirement savings.
Start by contributing to your 401(k) until you’ve maxed out your employer matching. Any matching you get from your employer is like free money, and it’s worth dealing with hefty 401(k) fees to get the match.
After you’ve maxed out your 401(k) match, start contributing to an IRA if you’re fully eligible to contribute and take the deduction. Using an IRA gives you more flexibility and lets you avoid the high fees common with many 401(k)s.
Once you’ve maxed out your IRA contributions, you can go back to contributing to your 401(k). Even if your plan has high fees, the tax benefits are usually worth it, especially if you make enough to max out both your employer match and your IRA contributions.
If you manage to max out both your 401(k) and IRA, it’s time to switch to a taxable brokerage account if you aren’t already using one.
IRAs and 401(k)s are two common ways to save for retirement. While 401(k)s offer much higher contribution limits, they restrict you when it comes time to choose your investments. IRAs are far more flexible, but you can’t contribute nearly as much to an IRA.
Choosing between the two and knowing how to prioritize each can be difficult. If you need help, reach out to a financial advisor. They can help you come up with a retirement plan that integrates your 401(k) and IRA and uses both to their full potential.
Do you contribute to a 401(k), IRA, or both? Why?