What are IRAs and 401(k)s?
Editorial staff, J.P. Morgan Wealth Management
- Investing for retirement is one of the most important steps you can take toward building a secure financial future for you and your family.
- Contributing to a retirement account can help you work toward your goals and may provide tax advantages to boost your progress.
- You may be able to take advantage of a workplace retirement plan, such as a 401(k), open an Individual Retirement Account (IRA), or use both.
When investing for retirement, two common types of accounts you may see are 401(k)s and Individual Retirement Accounts (IRAs). A 401(k) is an employer-sponsored plan that allows plan participants to contribute a portion of their paycheck to save for retirement. One potential benefit of a 401(k) is that your employer may match your contributions to your account up to a certain point. If this is available to you, then a good goal is to contribute at least enough to receive the maximum matching contribution your employer offers. Unlike a 401(k), an IRA is an account you generally open on your own.
Investing in an employer-sponsored qualified plan like a 401(k) or retirement account like a Roth IRA can expose you to a variety of investments, including stocks, bonds and/or mutual funds. These accounts are also tax-advantaged, meaning earnings, if any, are tax-deferred. Investing in a 401(k) may have the additional benefit of employer contributions such as matching. However, there are yearly contribution limits, and your investment returns are generally not accessible (without additional income tax) until you turn the retirement age defined in your IRA or 401(k) plan.
IRAs and 401(k)s typically come in two main types: traditional and Roth. While they have differences, both options allow you to save in a tax-advantaged way.
Traditional accounts
Contributions to traditional, or “pre-tax” 401(k)s, are deducted from your taxable income, while contributions to traditional IRAs may be tax-deductible.
For an IRA, this means that you may be able to deduct your contributions from your income for tax purposes, possibly reducing the amount of taxes you pay. Even if you aren’t eligible for a tax deduction, you are still allowed to make a contribution to a traditional IRA as long as you have taxable compensation.
When it comes time to withdraw money from traditional IRAs or 401(k)s, distributions are generally taxed as ordinary income.
Roth accounts
With Roth IRAs and Roth 401(k)s, you contribute after-tax dollars, and the withdrawals you take are tax-free as long as they are “qualified distributions,” as defined by the Internal Revenue Service (IRS).
For Roth IRAs, keep in mind that your income may limit the amount you can contribute, or whether you can contribute at all. If a Roth 401(k) is offered by your employer, the main benefit is that your ability to contribute typically isn’t phased out when your income reaches a certain level.
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What are the differences between IRAs and 401(k)s?
One of the biggest differences between 401(k) plans and IRAs is that 401(k)s are managed by employers, whereas IRAs are managed by individuals. Other differences include the variety of the investments and the tax implications of each.
Traditional IRA and 401(k) contributions aren’t taxed when you add money to the account; instead, you’re taxed on your withdrawals. In contrast, Roth IRAs and Roth 401(k)s are funded with money that’s already taxed as income, which means you don’t pay taxes on what you withdraw later on. These differences may contribute to why you might not be sure which retirement account is right for you.
Helpful reminders
- When investing for retirement, you may be able to use both a 401(k) and an IRA with both Roth and traditional account types; the options available to you may depend on a number of factors.
- While there are some exceptions to the rule, withdrawals from IRAs and 401(k)s before age 59½ typically trigger an additional 10% early withdrawal tax.
Next steps
- Ask your employer about your retirement plan options at work. If your employer offers a 401(k) option, check if you are enrolled and can start investing
- If your employer matches contributions, consider putting in at least enough to receive the full match
- If your employer doesn’t offer a 401(k) option or you’d like to increase your retirement savings, consider opening an IRA
- If you have questions about your personal situation, talk to your tax advisor
Frequently asked questions about IRAs and 401(k)s
401(k)s and IRAs are not the same; though there are some similarities. A 401(k) is a type of employer-sponsored qualified retirement plan that allows the employees of an employer to save and invest for retirement on a tax-advantaged basis. An IRA, which stands for “Individual Retirement Account,” also allows an individual to save and invest for retirement on a tax-advantaged basis, but it’s not made available through an employer. Rather, an individual can choose to open one at an investment firm. 401(k)s and IRAs benefit from tax-advantaged investing – investment growth, if any (capital gains, interest, dividends) that occurs in a 401(k) or IRA typically won’t be taxed while held in the account.
An IRA is a tax-advantaged account intended to help an individual save and invest for their retirement. You can contribute up to a certain amount every year and generally won’t be able to access the money without penalty until age 59 ½. Two of the most common types of IRAs are Traditional and Roth. Traditional IRA contributions are potentially tax-deductible, and earnings, if any, are tax-deferred until withdrawn. Contributions to a Roth IRA are not tax-deductible and are potentially limited based on your filing status and income. Earnings, if any, in a Roth are tax-deferred and can be withdrawn exempt from federal taxes if certain conditions are met.
Yes. If you have access to a 401(k) through your employer you can choose to make contributions. Additionally, you could open an IRA through an investment firm.
Yes. It’s possible to lose money in either an IRA or 401(k), particularly if you choose to invest your contributions in investments that are more risky. It’s also common for the value of your investment assets to go down during times of economic uncertainty.
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Editorial staff, J.P. Morgan Wealth Management
