And The Two Best Accounts For Retirement Savings Are...
Saving for retirement can be daunting... and the finance industry’s love for confusing acronyms doesn’t help. So, what’s the difference between an IRA and a 401(k)? Do those differences even matter? Let’s explore the basics, to prepare you to build wealth.
Why should you care about investing for retirement? Fair question — retirement can seem like a hazy event in the future, making it feel far less urgent than other life priorities. However, let’s learn from our parents — not saving early enough for retirement is the number one financial regret of Baby Boomers in America. In contrast, I have never heard anyone say they regret saving too much for retirement, too early.
Further, investing a modest amount today can be more powerful than investing a larger sum later in life. The power of compound interest means that the earlier you invest, the sooner your investments start growing and making money on your behalf. You can never, ever recapture time. Starting today with smaller amounts will build financial momentum in your investment accounts.
Finally, women should care about investing for retirement because we face a retirement gender gap. We tend to live longer, face a wage gap over the length of our careers, and spend more time out of the workforce than men. On average, we need to save $1.25 for every $1 saved by men.
What type of account is best — an IRA or a 401(k)? Once you’ve decided to invest, it’s time to identify the best type of account for your retirement investing. Let me be clear: either an IRA or a 401(k) is better than doing nothing. Both are fabulous options that are set up to encourage investing. Don’t spend months trying to make the perfect choice; you’ll lose valuable time where your money could be in the market, growing for you.
If you’d like to learn more details about investing, here’s how to start investing in four steps. I’ve also created a very simple summary of what investing in the market really means. Here’s a summary of the main differences between an IRA and 401(k):
Traditional 401(k) Account: Offered by your employer, this account allows you to invest a percentage of your wages for retirement.
- 401(k) accounts are funded with pre-tax wages. This means you pay less in taxes to the IRS. It also means you’re investing a larger amount of money (since you’re investing a full dollar earned, not just the portion remaining after taxes are paid).
- Many employers will “match” a portion of your savings. This is free money; never pass up free money!
- You pay taxes on the money when you withdraw it in retirement.
- In 2017, you can save up to $18,000 annually in a 401(k) — more if you are over 50.
- Generally, you cannot access the funds in a 401(k) account without paying steep penalties until you reach retirement.
- 401(k) is the subsection of the Internal Revenue Code that defines how these accounts work, hence the name of this retirement vehicle.
Traditional Individual Retirement Account (IRA): You have to open this account for yourself at a qualified bank or broker, like Vanguard or Fidelity.
- Traditional IRAs are funded with wages that you have already paid taxes on. However, depending on your income, you may be able to deduct your contributions from your taxes.
- You pay taxes on the money when you withdraw it in retirement.
- In 2017, you can save up to $5,500 annually in an IRA — more if you are over 50. The limit is far lower than 401(k) limits in most cases.
- Funds in an IRA account are for your retirement, but certain qualifying expenses allow you to skirt tax penalties. These include higher education expenses, a first-time home purchase and medical costs.
In addition to the differences above, 401(k) and IRA accounts may come in two flavors: Traditional and Roth.
- Traditional accounts have been funded with money that hasn’t been taxed, so you pay taxes on the money when you access it in retirement. (Traditional IRA investments receive a tax deduction, which makes it the same as a pre-tax 401(k) investment.)
- Roth accounts are funded with money that has already been taxed, so you do not owe the government any taxes when you access it in retirement.
So, which is the right type of account for you? Like many financial answers, it depends. In general, I recommend prioritizing a 401(k) account, because it often includes both employer matching funds, and you can save far more money for your retirement, in one place.
That said, the best advice I can give you is to make an informed decision quickly, and start investing (or, increasing your investing). Every day that passes without your money in the market is another day that you’re missing out on the amazing power of compound interest. So, get investing — you’ve got this!
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The Feminist Financier is on a mission to help women build wealth and own their financial independence, by improving financial literacy and taking the mystery out of money. Ms. Financier is also a shoe addict, travel fanatic, and wine enthusiast.