When employers intend to give their employees a tax-advantaged opportunity to save money for retirement, they usually offer them to participate in a 401(k) plan. Some employers also offer a Simplified Employee Pension or a Savings Incentive Match Plan for Employees, if the company has a team of 100 or fewer employees.
Employees can open a traditional or Roth IRA separately from their employer. However, they only have access to a SIMPLE IRA, SEP IRA, or 401(k) when offered by an employer. As the names suggest, Simple IRA’s and SEP aim to make it convenient for employers to initiate a retirement plan for employees and have fewer administrative challenges than 401(k) plans.
Let us take a look at both 401 (k) and IRA to understand how they work.
IRAs
There are numerous types of IRA’s. An IRA or individual retirement account can be either Roth or traditional. In both cases, it refers to a tax-deferred retirement savings account that an individual establishes. Employers offer SIMPLE or SEP IRA’s to their employees.
Similar to 401 (k)s, the contributions you make to a traditional IRA are tax-deductible. Returns and earnings mature tax-free, and employees pay tax on withdrawals at the time of their retirement. Contributions you make to a Roth IRA are subject to tax, but withdrawals are tax-free when you retire.
401(k)s
A 401(k) refers to a tax-deferred retirement savings account that employers offer to their employees, in which employees contribute a share to their account. Employers also contribute to this account by choosing a percentage of what their employees contribute.
All contributions that you make to 401 (k) are pre-tax. The sponsor chooses various investments, generally a line-up of mutual funds, to deposit the money. All fund choices must meet a certain risk tolerance so employees can take a calculated and comfortable risk.
How to Choose the Best Option
When your employer offers a retirement plan, such as 403 (b) or 401 (k), the company matches a percentage of your contributions. Hence, employees should benefit from this opportunity to receive free money into their account. Moreover, you will get a tax-deferred account, which makes saving easier by means of automatic payroll deduction.
However, in case your employer is not offering a plan, an IRA is usually a great way to save for your retirement and a way for your earnings to grow tax-free.
If employers offer a Matching Percentage
When your employer is matching your 401 (k) contributions, it means that the company you work at is contributing a certain amount to your savings that correspond to the amount of your personal annual contribution.
Depending on the conditions of your employer’s 401(k) plan, your employer makes contributions in several ways to match yours. Generally, employers match a percentage up to a certain portion of their employee’s total salary.
In some cases, employers also choose to match employee contributions up to a certain amount, regardless of the compensation they are offering to the employee.
The terms of 401(k), plans can vary. Other than adhering to the required contribution limits and withdrawal rules and regulations set by ERISA or the Employee Retirement Income Security Act, the sponsoring employer defines the terms and conditions of each 401(k) plan.
Generally, employers choose to implement a generous matching formula, or they may decide not to match employee contributions at all. Hence, some 401(k) plans can offer a more generous match than others. Regardless of the percentage that they wish to match, you get a steady stream of free money in your retirement savings.
Employees can refer to the rules and regulations of their plan to verify if and when their employer makes matching contributions. Regardless of employee contributions, some employers choose to make regular deferrals to employee plans. However, this is not common.
If Your Employer Does Not Offer a Matching Percentage
Employees should contribute enough for earning the full match if the employer offers a 401 (k) match. By checking your employee benefits handbook, you can see whether your employer matches any part of the funds you contribute to the 401(k) plan your company offers.
A company matching program is a great benefit of a 401 (k) plan. Your employer will contribute money to your account as per the amount of money you are able to save, but up to a limit. Most employers match a percentage of the amount employees save up to the first 6% of their earnings.
Even when the 401 (k) plan has a higher fee or limited investment choices, you should be able to carve out enough funds from your salary to benefit from the full company match. Moreover, employer contributions don’t count toward the 401(k) annual contribution limit.
The next step is to contribute as much money as you can (or allowed to) to your IRA. You get your tax break according to the type of IRA you choose, Roth or traditional.
If you prefer an immediate tax break, a traditional IRA is ideal for you. All contributions are deductible, and your taxable income for the year will be reduced by how much you contribute. However, when you are also covered by a 401(k), you can benefit from a reduced or no deduction, according to your income. In case an employee or their spouse has a workplace retirement plan, the employee will have to check out the IRA limits.
When you are not eligible to deduct traditional IRA contributions, you should opt for Roth IRA. That means you don’t mind giving up the IRA’s immediate tax deduction to benefit from tax-free growth on investments, as well as tax-free withdrawals in retirement. Your participation in a 401 (k) plan does not affect your Roth IRA eligibility.
When Can Your Ignore 401 (k)?
In some cases, investing in a 401(k) does not offer any major benefits. For instance, if the fees you pay counteracts your projected returns, you can choose to skip 401 (k). The Department of Labor has set up strict regulations to make fee disclosures transparent. However, thousands of participants continue to remain ignorant of the amount they are actually paying.
When you save your money in an IRA instead, it means you can’t save as much because the annual contribution limit is lower. However, you can still escape a part of the hefty fees. If you don’t intend to stick to your current employer for a longer period, contributing to an IRA and not participating in the 401(k) plan will save you the hassle of rolling it over when you move on.
The contributions you make to a 401(k) account are on a tax-deferred basis, which means you don’t owe anything to the government until you start withdrawing money. In case you expect to shift to a lower tax bracket at the time of your retirement, that’s not a big deal. However, the same could be a problem if your salary is about to increase in the future.
Final Thoughts
Both 401 (k)s and IRAs provide tax benefits to your retirement funds, so it is a great idea to make contributions to both. Otherwise, you can get any 401 (k) match and max out your Roth or conventional IRA to maximize your returns and reduce your costs.
