Saving for Retirement: 401K vs IRA vs Nothing

Whether you’re just starting your career, switching jobs, or you’ve been working for three decades, making sure you’re saving for retirement is one of the most important things you can do to set yourself up for the future. And the sooner you start saving, the better off you’ll be financially. After all, of those who participated in the Charles Schwab 2018 401K Participant Survey, 60 percent said their 401K will be their largest source of income when they retire.

In that same survey, though, 40 percent said saving enough money for a comfortable retirement was their most significant source of financial stress. And with all of the retirement savings options available, you may be feeling the stress too. It can be difficult to navigate what retirement savings vehicle is best for you, especially if financial knowledge isn’t your strong suit. The two most-common ways to save for retirement are a 401K and an Individual Retirement Account. Both are great tax-advantaged options, but it is a common misconception that you have to choose one or the other. Some people who are aggressively saving for retirement have both a 401K and an IRA.

What is a 401K?

A 401K is an employer-sponsored program that allows eligible employees of a company to save and invest a percentage of their own salary for retirement without paying taxes on it, according to Rosanna Guardavaccaro, financial advisor with Strategies for Wealth in Rye Brook and The Guardian Life Insurance Company of America. This savings plan allows you to put away up to $18,500 each year. Only an employer can sponsor a 401K for its employees, and this includes if you work for yourself.

If you are lucky enough to work for a company that offers a 401K, especially one that will make a matching contribution, Daniel D’Ordine, CPF, founder of DDO Advisory Services in Rhinebeck, suggests taking advantage of this opportunity and contributing at least the matching percentage, if it’s financially feasible for you to do so. For example, if your employer will make a matching contribution of up to 6 percent of your salary, you should contribute 6 percent of your salary to your 401K.

There are a handful of benefits to a 401K. “Contribution limits are so high that you can really lower your current income tax bill by taking money and putting it into your 401K,” D’Ordine says. If you live in a high tax area, this is especially valuable because you are lowering your tax bracket by contributing to your 401K. For example, if you pocket $12,000 of your paycheck, you will have to pay up to 40 percent of taxes on that amount. However, if you put that same $12,000 into your 401K, it’s tax-free money and you have the opportunity to have a portion of that matched by your company (aka free money for you). 

Another advantage is a 401K is essentially ‘automated invisible savings,’ D’Ordine says. “Once you can adjust to this slight reduction in your paycheck, the savings are happening automatically,” he says. “You forget about it and it takes away the emotional component of saving.”

Another great advantage is investing in a 401K is dollar-cost averaging, which means you are investing a fixed dollar amount on a regular schedule and any market fluctuations will not affect this investment, according to D’Ordine. This further removes the emotional component because you are investing your money without any associated volatility. Should your salary or your financial situation change, you can change your investment contributions on a quarterly or yearly basis, depending on your company’s policy. 

What is an IRA?

An IRA is a mini-federal retirement account you can set up on your own, without sponsorship from an employer, according to D’Ordine. An investment custodian, a bank, a mutual fund company, or an advisor can help you set up a traditional or Roth IRA. With both IRAs, you can put away up to $5,500 each year, plus an additional $1,000 if you are older than 50.

The difference between the two is in contributions. When you contribute to a traditional IRA, you can claim the contribution on your tax return that same year. This means you will pay taxes on them when you retire, according to Guardavaccaro. But you might not get the full amount back. If your employer offers a retirement plan and your income exceeds certain levels, your deduction may be limited; if your employer doesn’t offer a retirement plan, your deduction is allowed in full, according to the Internal Revenue Service. With a Roth IRA contributions are not tax-deductible, and since you’ve already paid taxes on what you contributed, you will receive that sum of money completely tax-free when you retire.