You want your retirement years to be golden ones, so it is important to save and plan for them as soon as possible. IRAs and 401ks are vehicles to efficiently invest money for retirement. Each has its own set of rules and respective advantages and disadvantages. Examine your options to see which is better for you.
401k Essential Facts
You can't just walk in off the street and get a 401k. They are employer-sponsored plans available only through work. You self-fund the plan out of your own salary with pretax dollars, which means that the money comes through a tax-deductible payroll deduction. As your account grows, you also do not pay tax on dividends or capital gains. However, 401ks are tax deferred, so although you pay no taxes now you will have to pay income tax on mandatory account withdrawals once you reach retirement age. If your employer offers a match, in which the company puts its own money into your 401k to match the amount you put in yourself, this is the best deal you'll find. That match is an instant return of up to100 percent on your investment, and you won't do better than that.
Traditional IRA Essential Facts
A traditional IRA shares many similarities with a 401k, but it isentirely self-funded outside of the workplace. Anyone who meets the government-stipulated income requirements may invest in a traditional IRA. Depending on your income level, all or a portion of the contribution is tax deductible. Taxes are deferred until you take required withdrawals upon retirement.
Roth IRA Essential Facts
Like a traditional IRA, a Roth IRA is a self-funded plan open to anyone who meets the income eligibility requirements. However, a Roth is different because the initial investments are made with taxable dollars and you can't take any immediate deductions. Roth IRAs, however, are the darlings of many investors because the account grows without taxes, and upon retirement you pay no taxes when you take distributions. Unlike a traditional IRA and 401k, there is no mandatory distribution at any age.
Taxes Now or Later
If a tax break now enables you to save for retirement, a 401k or traditional IRA might be better options. If you don't really need the tax break now and expect that tax rates will be higher on the day you retire than they are on the day you invest, then a Roth IRA is probably better.
Some 401ks are held with large financial services companies that offer a vast array of mutual funds and similar investments. Other companies only provide a limited range of choices, such as stock in the employer itself or only a small portfolio of mutual funds. IRA and Roth IRA investors are free to select their own financial services company, so if the ability to choose from a dizzying cornucopia of investments is what you're looking for, the IRA route could be better for you.
Investing in Both
Your better option might be to invest in both an IRA and a 401k, which you may do as long as you do not exceed the income requirements or the maximum annual contributions. Check with the IRS for contribution limits because they change every few years.
Annabella Gualdoni has written newsletters and reports for corporations and nonprofits since 1994. She is a real estate professional and also teaches subjects including international cooking and travel, dating/relationships and personal finance. Gualdoni has a Bachelor of Arts in international development from University of California, Berkeley, a Master of Arts in international relations from Boston University, and a Juris Doctor from Boston College Law School.