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When you're planning for retirement, it can be a bit confusing to decide exactly how to invest your money. Many employers offer 401(k) plans for their workers, but some may wonder if an IRA would offer a better investment return. Here's a look at the differences between a 401(k) plan and an IRA. Comparing both forms of investment can help you decide which one is better for you.
401(k) Vs. IRA
A 401(k)is a traditional employer-provided retirement plan. As a result, you cannot sign up for a 401(k) plan on your own. When you enroll in a 401(k), a portion of your paycheck is automatically diverted to the fund each pay period before taxes are withheld. Your employer may also contribute to the fund each pay period. Since the plan is administered through your employer, you may have to wait until you reach a certain age or number of years with the company before you can withdraw the funds.
An Individual Retirement Account (IRA) is different, because you can establish it yourself. You can decide how much money you want to contribute to it each year and you can withdraw it whenever you choose. However, you may have to pay a penalty if you remove the funds before you reach a certain age.
How 401(k)s Are Taxed
As mentioned earlier, your contributions to a 401(k) plan are diverted before taxes are withheld from your check. This means that your 401(k) contributions are exempt from taxation at the time they are made. When you withdraw the funds, you'll be subject to federal and state income taxes on those proceeds, as well as any interest that has accrued since the original contribution was made.
How IRAs Are Taxed
Traditional IRAs are also taxed at the time of withdrawal. While IRA contributions are not exempt from tax, they are used as tax deductions. As a result, the funds are taxable when they are removed from the account. A major exception to this rule is the Roth IRA.
The Roth IRA is a more flexible investment plan than the traditional IRA. Roth contributions are taxable at the time they are made, so there are no instant tax savings when you contribute. However, when you withdraw funds from a Roth IRA, both the funds and the interest are tax-exempt. That means that if you earn a substantial amount of interest over the years, you could avoid paying tax on it all when you withdraw your funds. To qualify for the tax exemption, you must leave your funds in a Roth IRA for at least five years before withdrawal.
While 401(k) plans and IRAs both offer retirement planning, they are very different investment vehicles. Take a good look at your financial situation and your retirement goals before you decide which investment is better for you.
