Why is financial literacy important? It provides us the knowledge and skills needed to effectively manage our money! Yet many people have unanswered questions about budgeting, investing and repaying debt. According to Google.com, the most common financial searches in Connecticut are “What’s a 401k” and “Is a 401k the same as an IRA?”
What Is a 401(k)?
A 401(k) is a company-sponsored retirement account that employees can contribute income to, while employers may match contributions. There are two main types of 401(k) plans:
- Traditional 401(k): Employees save for retirement on a pre-tax basis and don’t pay taxes on contributions. The money can grow tax-deferred until withdrawn at retirement, starting at age 59 ½. Withdrawals will then be taxed as ordinary income. After age 72, you will have to take required minimum distributions each year.
- Roth 401(k): Employees save for retirement using after-tax money and pay taxes on those contributions. Money can grow tax-free and be withdrawn in retirement after age 59 ½, also tax-free. At age 72, you will be required to take minimum distributions.
Money can grow tax-deferred or tax-free in a 401(k), until withdrawn at retirement age. Employees can deduct a portion of each paycheck to be invested in stock mutual funds and other potentially high-returning assets.
According to the US Census Bureau, 32 percent of Americans invested in a 401(k) as of 2021.
As of 2022, the annual contribution limit to a 401(k) is $20,500. Those over age 50 can make a $6,500 catch-up contribution each year.
What Is an IRA?
An Individual Retirement Account (IRA), set up at a financial institution, allows you to save for retirement with tax-free growth or on a tax-deferred basis. There are three main types:
- Traditional IRA: Contributions may be deductible on your annual tax return. Any earnings can potentially grow tax-deferred until withdrawn in retirement.
- Roth IRA: Contributions are made with after-tax money and may potentially grow tax-free under certain conditions, with non-taxed withdrawals in retirement.
- Rollover IRA: Money can be “rolled over” into a Traditional IRA from a qualified retirement plan, such as a 401(k) or 403(b).
Anyone with earned income, including spouses, can save for retirement on a tax-advantaged basis. Money is compounded at higher rate, so you can accumulate more money over time!
As of 2022, the annual contribution limit to an IRA plan is $6,000. Those over age 50 can contribute an additional $1,000 each year.
Which Retirement Plan Is Best?
Choosing the retirement plan that’s right for you depends on the features you value most. A 401(k) allows for more money to be contributed each year on a pre-tax basis and may be easier to manage for those who do not want to make investment decisions.
On the other hand, an IRA plan can offer more investment choices, including CDs, stocks, bonds, mutual funds and ETFs. A broker will manage your investments and hold money in an IRA savings account, which many 401(k)s do not allow.
Saving for retirement doesn’t have to be a burden! To learn more about available account options, contact Ion Bank today.