A 401(k) and an IRA are retirement savings accounts with tax advantages. A 401(k) is offered through an employer, while an IRA is opened independently. Many people use both to maximize contributions, tax benefits and long-term flexibility.
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Key Facts to Know About 401(k) and IRA Retirement Accounts
Key takeaways
- A 401(k) is typically offered through an employer, while an IRA is opened by an individual; both can help you save for retirement.
- Employer contribution matching can help boost retirement savings, making it important to understand your company’s 401(k) plan.
- Compounding can help retirement accounts grow over time because earnings may generate additional earnings.
- Traditional 401(k)s and IRAs may offer tax advantages, and even modest contributions can help support long-term retirement goals.
Having an investment account to draw from in retirement can make a world of difference when it comes to making ends meet. While the income from Social Security is vital, many also contribute to either 401(k) or IRA accounts to supplement their retirement income.
A 401(k)-retirement plan is a benefit that is offered by employers, while an IRA is a retirement plan that is set up by individuals. Both are managed by professionals, and either option is a great way to invest for the future.
Here are some key facts about retirement accounts to consider from James Beam, Head of Wealth Distribution, TD Wealth®.
How should I decide between a 401(k) and an IRA?
If your employer offers a 401(k) match, contributing enough to receive the full match is often a strong first step. After that, an IRA may offer additional flexibility and investment choice. Many people use both to balance employer benefits with individual control.
How does employer matching work in a 401(k)?
Who doesn’t love getting "free" money? If you work for a company that offers a 401(k) with employer contribution matching, that’s exactly what you’ll get every time you contribute to your retirement account. The amount that each employer matches varies so it's good to review the plan at your company. Employer contribution matching dramatically increases the growth of your retirement account. For those with tighter budgets, employer contribution matching can help you reach your retirement goals when you aren’t able to contribute as much as you would like.
How does compounding help retirement savings grow?
When you invest in either a 401(k) or IRA, the money you contribute doesn’t just sit there — it may earn interest. But that’s not the end of the story. Through an investment principle known as compounding interest, your account will earn interest on the contributions and interest from previous years.
If you make steady contributions and the interest you are earning is compounding, your account may grow into a sizable investment over time. How frequently your 401(k) or IRA compounds depends on the assets you have in your portfolio. It could be either monthly or annually.
What are the tax benefits of a 401(k) or IRA?
When you invest in either a traditional 401(k) or IRA, you get two important tax breaks. These breaks allow you to put all your retirement money to work earning interest and compounding so that your account will continue to grow each year.
First, the contributions you make to your retirement account are tax-deductible. This means the money you contribute doesn’t count towards your gross income for the year, which lowers your taxable income.
Second, the money you invest in your retirement account grows tax deferred. This means you don’t have to report the interest you earn each year on your taxes. With a traditional 401(k) or IRA, taxes are paid when you make withdrawals.
Are 401(k)s and IRAs professionally managed?
When you invest in a 401(k) or IRA, your money may be managed by professionals. The fees for this service are modest and vary depending on the organization that oversees your account. The fee range is typically 0.5% to 2% of the value of your account annually.
When should you start saving for retirement?
Many people postpone setting up retirement accounts because they may not think they can contribute enough to make a difference. When money is tight, they may have their hands full making mortgage payments, funding their kids’ college educations, and other things. With inflation currently at a 40-year high, finding new ways to stretch a dollar is easier said than done.
The sooner you can start investing for your retirement, the better. Each additional year that you can invest is another year that your account can grow through the compounding of interest and previous contributions.
It’s also never too late to get started. Even if you are only able to make a modest contribution every month, you will still be working towards growing a retirement account that you can use to supplement your Social Security. Every contribution you can make is important, and you’ll be glad to have it when you reach retirement.
FAQs
A 401(k) is typically offered through an employer, while an IRA is opened by an individual. Both are designed to help people save for retirement and may offer tax advantages.
An employer match means your employer contributes additional money to your 401(k) based on how much you contribute, up to the limits set by your plan. Because matching amounts vary by company, it’s a good idea to review your employer’s plan details.
Compounding means your account may earn returns not only on your original contributions, but also on previous earnings. Over time, steady contributions and compounding can help retirement savings grow.
Traditional 401(k)s and IRAs may allow contributions to be tax-deductible and investments to grow tax deferred. Taxes are generally paid when withdrawals are made.
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