Saving for retirement is important for your financial security but choosing the best way to do that can be confusing. Vehicles like IRAs and 401(k) plans offer tax savings and benefits for long-term savers, but which fund allocation strategy is best for you?
What Are the Differences Between a 401(k) and an IRA?
The primary difference between the two accounts is that 401(k)s are offered only through employers who choose to offer them, while any individual can open an IRA account through a bank, a brokerage firm or an insurance company.
The good news is that you may be able to contribute to both a 401(k) and an IRA. If you’re employed by a company that offers a 401(k), contribute to it as soon as you are eligible. If you max out your 401(k) contribution and have additional income, consider contributing to a traditional IRA.
Do 401(k) and IRA Plans Have Matching Funds?
The first step to deciding how to allocate your money is to find out whether your employer offers a 401(k) — and whether they will match your contributions. If the answers are yes to both, you’ll likely want to take advantage of that before doing anything else — it’s essentially free money from your employer. Contribute the maximum amount to the 401(k) so you’ll get the maximum match your employer offers.
If you want to invest additional funds, the next step is to open an IRA — either a traditional or Roth. A traditional IRA can offer an immediate tax break; depending on factors like your income and contributions to a 401(k), the contributions may be deductible. A Roth IRA might be a better choice if you can’t deduct traditional IRA contributions or if you’d prefer tax-free withdrawals during retirement over deductions now. However, take note: your income has to be below a certain level to contribute to a Roth.
IRAs do not have an employer match and have lower maximum contribution limits than a 401(k). The contribution limit for a 401(k) in 2022 is $20,500 ($27,000 if you’re 50 or older), while the limit for most IRAs is $6,000 ($7,000 if you’re 50 or older).
When Should You Start an IRA?
If your employer doesn’t offer matching funds for a 401(k), it may be best to allocate your funds toward an IRA and contribute as much as you can, to the allowable limit. The IRA’s benefits include access to more investment options than most 401(k)s offer, giving you more control so you can diversify as you wish.
Once you fully fund the IRA, turn to the 401(k), if your employer offers one, and put your money there. Even without matching funds from your workplace there are benefits: Most importantly, contributions to a 401(k) will lower your taxable income for the year, so it’s still a good place to invest.