Katie Brockman The Motley Fool
Published 12:10 PM EDT Aug 15, 2019
When most people think of saving for retirement, they think about how much they need to save, how much retirement will cost and whether they’re saving enough to reach their goal. But where you put your savings can have just as much of an impact on your money as how much you’re stashing away.
The two major players in the retirement account game are the 401(k) and IRA. They both have strengths and weaknesses and choosing the right one can help your savings grow faster, giving you a better shot at retiring comfortably.
What is a 401(k)?
A 401(k) is a workplace retirement account offered through your employer. Only around 53% of employers offer defined contribution plans such as 401(k)s, according to a Pew survey, so if your employer doesn’t offer you one, you won’t have access to a 401(k).
If you are fortunate enough to have access to a 401(k), it can be an incredibly powerful saving tool – especially if your employer offers matching contributions. Employer matching contributions are essentially free money you receive simply by putting money in your 401(k). The most common type of match is $0.50 per dollar on up to 6% of your salary, according to a study from Vanguard. So if you’re earning $50,000 per year, that means your employer will match your contributions up to $1,500 per year.
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Another major perk that comes with 401(k) is the high annual contribution limit. In 2019, you’re able to contribute up to $19,000 per year to your 401(k), and those age 50 or older can save an additional $6,000 per year. This is a serious advantage for super savers and those behind on their savings, because if you save enough to max out your 401(k), you can accumulate a lot of money in a relatively short period of time.
However, the 401(k) has its downsides, too. For one, your investment options are limited. Because your 401(k) is offered through your employer, your employer decides what types of funds you can invest in – which is typically a few different mutual fund options. Generally speaking, there’s nothing wrong with these types of investments, though in some cases these funds charge high fees.
Every type of retirement account charges fees, and some have higher fees than others. The average 401(k) charges fees of around 1% of total assets managed, according to the Center for American Progress. So if you have $100,000 in your account, you’d pay $1,000 in fees each year. That may not sound like much, but the average worker paying 1% in fees will pay around $138,000 in fees over a lifetime, according to CAP. If your 401(k) charges higher-than-average fees, there’s not much you can do to lower them – and those fees can take a big bite of your savings over time.
What is an IRA?
There are two primary types of IRA: a traditional IRA and a Roth IRA. A Traditional IRA is very similar to a 401(k) in that you can contribute tax-deductible dollars, let them grow over time, and then pay income tax on the funds when you withdraw the money in retirement. With a Roth IRA, you pay taxes on your contributions upfront, but withdrawals are tax-free.
Other than the taxation aspect, traditional IRAs and Roth IRAs are very similar. These are private retirement accounts not offered through an employer, which has its advantages and disadvantages. The biggest downside is that you can’t earn any employer matching contributions with an IRA. But on the bright side, you have a much wider variety of investment options. So instead of being stuck with funds that charge high fees, which you might face with a 401(k), you can invest your money in lower-cost options, saving money over time.
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Another difference between IRAs and 401(k)s is the amount you can contribute each year. For both traditional and Roth IRAs, you’re limited to saving just $6,000 per year, or $7,000 per year for those age 50 or older. That can be a disadvantage for those looking to supercharge their savings, but if you’re not saving more than $500 per month, the contribution limit won’t affect you.
Which retirement account is right for you?
Choosing between a 401(k) and an IRA is a personal decision that depends on your individual situation.
If you have access to a 401(k) that offers employer matching contributions, it’s a good idea to save at least enough in that account to earn the full match. Even if your 401(k) plan charges high fees, the free money you earn can outweigh what you pay in fees. Not all 401(k)s offer matching contributions, though, so if that’s the case, you may be better off with an IRA – especially if you can find less expensive investment options than what’s offered with your 401(k).
Also, there’s no rule against contributing to both a 401(k) and an IRA. For instance, if your 401(k) offers matching contributions but also charges high fees, you may choose to contribute enough to earn the full match, then put the rest of your savings in an IRA. Then if you max out your IRA, you can put any additional savings in your 401(k). (Even if you’re paying higher fees on those additional savings, it’s still better than saving nothing once you’ve maxed out your IRA.)
There’s no right answer when it comes to deciding between a 401(k) and an IRA. Both are solid investment options with benefits and drawbacks, but by using one or both of them to your advantage, you can make the most of your money and save even more for retirement.
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