Saving for retirement is an important goal, especially if you have your debt under control and the extra savings available. But choosing to invest in either a 401(k) vs an IRA can be confusing. There are different income and tax factors for each, so how do you know which one you should use?
Let’s take a look at the differences between an IRA vs 401(k) in terms of how much you can contribute, how they’re taxed, and the pros and cons.
Individual Retirement Account: Traditional vs. Roth
An Individual Retirement Account (or IRA for short) allows you, as an individual, to contribute and save up money for your future retirement. You can set up an account at your bank or other financial institution.
Depending on the type of the IRA you choose, there are several ways to benefit from tax-free growth or tax-deferred savings. There are two main types of IRAs with different tax advantages of each.
A Traditional IRA is has two main benefits: you may qualify for a tax deduction on the money you contribute and the income earned in the account accumulates on a tax-deferred basis. You can start taking withdrawals at age 59 ½, at which point the money will be taxed as regular income.
With a Traditional IRA, there is no income limit, so you can open an account and save for retirement no matter how much money you earn. The maximum amount you can contribute in 2016 is $5,500 for individuals under 50 years old, or $6,500 for individuals 50 years or older.
You’ll want to choose a Traditional IRA if your income is too high to contribute to another type of retirement plan, or in the event you want to receive a yearly tax deduction on your income taxes.
The main drawback is that you likely have no way of knowing what your income tax bracket will be when you reach retirement age, and therefore, could be paying out a large amount of taxes when you withdraw funds. In addition, a Traditional IRA comes with a Required Minimum Distribution (RMD) when you hit age 70 ½, forcing you to take out funds on a yearly basis.
A Roth IRA has opposite tax advantages from the Traditional IRA. Instead of receiving a tax deduction and contributing pre-tax funds, the money earned and withdrawn from a Roth IRA is completely tax-free in retirement. You may also take out money to use penalty-free for qualified purchases, like buying your first home or higher education.
Not everyone qualifies for a Roth IRA, though, as there are certain income limitations. In 2016, you must have an adjusted gross income AGI) of less than $116,000 as an individual or $183,000 for a married couple filing jointly.
Like with the Traditional IRA, the maximum amount you can contribute in 2016 is $5,500 for individuals under 50 years old, or $6,500 for individuals 50 years or older. You’ll want to choose a Roth IRA if you’re a young adult and have many years ahead of you to save for retirement, as your tax situation will likely drastically change as you reach retirement age.
You may also be interested in forgoing the tax deduction in favor of tax-free withdrawals in the future. Unlike a Traditional IRA, there are no Required Minimum Distributions, so you can leave the funds in your account as long as you wish.
The main drawback is that there’s an income limit, but as a young adult, you will likely not be affected by this limitation.
Employer-sponsored plan: 401(k)
There are many types of employer-sponsored retirement plans and a 401(k) is one of the most popular ones. It allows you, the employee, to save and invest part of your paycheck each payment period before taxes are taken out.
There are several different types of 401(k)s available, but we’re going to focus on the most common one.
A Traditional 401(k) is the most common plan and allows both employers and employees to contribute pre-taxed money into a retirement account for the benefit of that employee. This means you won’t have to pay taxes on that money during the year you earned it, but instead, pay them when you withdraw it during retirement.
You may choose how your funds are invested and can only access them if you change jobs or reach retirement age. In 2016, employees who participate in a Traditional 401(k) are allowed to contribute up to $18,000 of pre-tax income, plus an additional $6,000 for individuals 50 years or older.
You’ll want to choose a Traditional 401(k) versus another type of 401(k) if you want to defer a larger portion of your income from paying taxes, and/or your employer offers a match to contribute an additional amount as you participate in the program. This is like receiving “free money” and can help you grow your retirement wealth quickly.
A similar drawback like with a Traditional IRA, the funds in your Traditional 401(k) will be taxed as regular income as you withdraw them during retirement age.
IRA vs. 401(k): Final thoughts
Use the pros and cons listed here to help decide which type of retirement account is best for your financial situation. In most cases, you’ll want to participate in your employer’s 401(k) or other sponsored retirement plan whenever possible since the contribution limits are higher and many employers offer a match.
If that’s not an option, you’ll want to check out the Roth IRA if you’re younger and expect to be in a higher tax bracket at retirement. If you’re an older adult, a Traditional IRA may be the best choice.
The biggest difference between a 401(k) and a Roth IRA are the tax implications and how that affects your contributions and withdrawals. A 401(k) is funded with pre-tax dollars, allowing a credit on your taxes, while a Roth IRA is funded with after-tax money and does not allow for any tax credits.
However, you will have to pay taxes on the funds you withdraw from your 401(k) during retirement, based on your current income tax bracket (which could be substantial after 40+ years on the job), while any money withdrawn from a Roth IRA during retirement is completely tax-free.
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1 Important Disclosures for Earnest.
To qualify, you must be a U.S. citizen or possess a 10-year (non-conditional) Permanent Resident Card, reside in a state Earnest lends in, and satisfy our minimum eligibility criteria. You may find more information on loan eligibility here: https://www.earnest.com/eligibility. Not all applicants will be approved for a loan, and not all applicants will qualify for the lowest rate. Approval and interest rate depend on the review of a complete application.
Earnest fixed rate loan rates range from 3.89% APR (with Auto Pay) to 5.87% APR (with Auto Pay). Variable rate loan rates range from 2.47% APR (with Auto Pay) to 5.87% APR (with Auto Pay). For variable rate loans, although the interest rate will vary after you are approved, the interest rate will never exceed 8.95% for loan terms 10 years or less. For loan terms of 10 years to 15 years, the interest rate will never exceed 9.95%. For loan terms over 15 years, the interest rate will never exceed 11.95% (the maximum rates for these loans). Earnest variable interest rate loans are based on a publicly available index, the one month London Interbank Offered Rate (LIBOR). Your rate will be calculated each month by adding a margin between 1.82% and 5.50% to the one month LIBOR. The rate will not increase more than once per month. Earnest rate ranges are current as of Month/Day/Year, and are subject to change based on market conditions and borrower eligibility.
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Laurel Road Disclosures
Savings example: average savings calculated based on single loans refinanced from 9/2013 to 12/2017 where borrowers’ previous rates were disclosed. Assumes same loan terms for previous and refinanced loans, and payments made to maturity with no prepayments. Actual savings for individual loans vary based on loan balance, interest rates, and other factors.
Application detail: 5 minutes indicates typical time it takes to complete application with applicant information readily available. It does not include time taken to provide underwriting decision or funding of the loan.
Instant rates mean a delivery of personalized rates for those individuals who provide sufficient information to return a rate. For instant rates a soft credit pull will be conducted, which will not affect your credit score. To proceed with an application, a hard credit pull will be required, which may affect your credit score.
Total savings calculated by aggregating individual average savings across total borrower population from 9/2013 to 12/2017. Individual average savings calculation based on single loans refinanced from 9/2013 to 12/2017 where borrowers’ previous rates were provided. Assumes same loan terms for previous and refinanced loans, and payments made to maturity with no prepayments. Actual savings for individual loans vary based on loan balance, interest rates, and other factors.
3 Important Disclosures for SoFi.
4 Important Disclosures for LendKey.
Refinancing via LendKey.com is only available for applicants with qualified private education loans from an eligible institution. Loans that were used for exam preparation classes, including, but not limited to, loans for LSAT, MCAT, GMAT, and GRE preparation, are not eligible for refinancing with a lender via LendKey.com. If you currently have any of these exam preparation loans, you should not include them in an application to refinance your student loans on this website. Applicants must be either U.S. citizens or Permanent Residents in an eligible state to qualify for a loan. Certain membership requirements (including the opening of a share account and any applicable association fees in connection with membership) may apply in the event that an applicant wishes to accept a loan offer from a credit union lender. Lenders participating on LendKey.com reserve the right to modify or discontinue the products, terms, and benefits offered on this website at any time without notice. LendKey Technologies, Inc. is not affiliated with, nor does it endorse, any educational institution.
5 Important Disclosures for CommonBond.
6 Important Disclosures for Citizens Bank.
Citizens Bank Disclosures
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|2.47% – 5.87%1||Undergrad & Graduate|
|2.47% – 8.03%4||Undergrad & Graduate|
|2.95% – 6.37%2||Undergrad & Graduate|
|2.48% – 6.25%5||Undergrad & Graduate|
|2.72% – 8.32%6||Undergrad & Graduate|