What is a 401k? What is an IRA? And equally important, Which one do you need? This cheat sheet should help steer your future in the right direction.
What is a 401(k)?
This employer-sponsored plan has a high contribution limit (in 2018, it’s $18,500), so you can streamline your savings in one account. Contribute pretax income—which may lower your tax bill this year—then pay taxes on the funds when you withdraw them during retirement, says Cathy Derus, a certified public accountant and CEO of Bright-water Financial in Chicago.
What is a Roth 401(k)?
Some employers also give you access to a Roth 401(k), which you may use instead of or in combination with a traditional 401(k). This account requires you to pay taxes on the money as you put it in, but then you can make withdrawals tax-free during retirement. That may mean you’ll get a bigger tax bill than if you opt for a traditional 401(k), but the trade-off could be more money in retirement. The combined contributions of your Roth and traditional 401(k) plans cannot exceed $18,500 (unless you’re 50 or over).
What is an Individual Retirement Account?
Like a 401(k), an IRA lets you make tax-deductible investments, which can help lower your next tax bill. “Deductions are limited based on how much you make and whether you’re contributing to an employer-sponsored plan,” says Derus. You can put in $5,500 a year before age 50 and $6,500 a year if you’re 50 or older. It’s a good option for those who are maxing out employer plans or wish to consolidate old plans.
What is a Roth IRA?
The Roth IRA is available to single filers earning less than $135,000 and joint filers earning less than $199,000. As with the Roth 401(k), you fork over tax on contributions and then make withdrawals tax-free during retirement. “A Roth IRA can make a lot of sense when you’re in your 20s and 30s,” says Coombes, because in the early years of your career you’re likely in a lower tax bracket than you’ll be in later. Avoid Roth plans if you expect your income to drop.