0.23 percent. That’s how little you can earn on average when stashing cash away in a bank savings account. Comparing that with an inflation rate of 6% in February 2023, you can hardly earn any return. In fact, you are losing money to inflation.
That’s why this is a good time to start thinking about where to put your retirement money, especially when banks are no longer safe after the collapse of Silicon Valley Bank. While there is a plethora of financial vehicles for you to invest your retirement fund, 401(k) and IRA are among the most well-known and safest options for retirees.
Bank interest rates are abysmal, offering only 0.23% APY on average.Source: BankRate
Basics of a 401(k) Plan
Here are some fundamentals you need to know about a 401(k). It serves as both a retirement savings and an investing plan offered by your employer. In essence, you can set up a salary deferal directly from your paycheck and into an investment pool, which includes an assortment of stocks, bonds, mutual funds, and annuities.
With an annual contribution limit of $22,500, you have the option to allocate your money toward two types of 401(k):
- Traditional 401(k): This option funnels a part of your paycheck into a 401(k) without paying a cut to Uncle Sam. That is, this 401(k)’s feature takes advantage of pre-tax money, reducing your taxable income and permitting more income to be invested. However, you ultimately will have to pay taxes when cashing out your investments.
- Roth 401(k): This option functions in a similar fashion to the traditional 401(k). The primary distinction is Roth uses after-tax dollars to make contributions. Your investment will grow tax-free while incubating in the fund, and more importantly, you won’t owe the IRS any obligation when withdrawing. Your contributions, interest earned, and capital gains all grow completely tax free in a Roth 401(k).
Basics of an IRA Plan
You might think IRA sounds like IRS, but they actually have nothing in common. IRA stands for individual retirement account, which is another investment vehicle that acts as retirement savings. You can open an IRA with different providers that also let you invest in various stocks, bonds, ETFs, and even insurance.
While there are many types of IRAs (SEP IRA, SIMPLE IRA, Rollover IRA), the most popular ones, similar to the 401(k), are Traditional and Roth IRA.
- Traditional IRA: You can deduct contributions to a Traditional IRA from your taxable income. But the IRS will require you to pay the deferred tax when making withdrawals. In addition, if you or your spouse already established a retirement account at work, the tax deductibility offered by the IRA can be limited.
- Roth IRA: There are no tax benefits when you opt for a Roth IRA at the beginning, as contributions are post-tax money. However, when you decide to withdraw your investments, the IRS won’t come knocking on your door. Roth IRA contributions grow completely tax free, including all interest, capital gains, and dividends earned. This puts a safeguard on your money if your tax liability is higher in the future than it is today.
401(k) vs. IRA
So, which retirement savings plan is better, and which one should you choose?
The answer is: why not both? There are no rules that forbid you from having both types of retirement accounts. Since the IRA generally has an annual contribution limit of $6,500, but tends to offer more investment choices, you can max out your IRA account and then allocate money to a 401(k) after. If, however, your employer offers 401(k) matching (when they also contribute to your retirement plan), you should deposit until earning a full match before switching to an IRA account. For a more efficient plan to allocate your retirement dollars, see our personal finance flowchart.