IRAs and 401(k)s offer similar tax perks, and financial experts recommend using both to save for retirement

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  • Financial experts recommend saving for retirement in both a 401(k) and an IRA.
  • A 401(k) is an employer-sponsored retirement plan in which you contribute money to an investment account. An IRA is a retirement investment account held at an independent financial institution.
  • 401(k)s and IRAs come in two varieties: Roth and traditional. The main difference between the two is when the money is taxed.
  • You can contribute a combined maximum of $25,500 to a 401(k) and an IRA in 2019 if you're under age 50. 
  • Use Blooom to analyze your 401(k) today and see how you can grow your retirement savings »

Believe it or not, it's possible to save for retirement on autopilot. You just have to know where and how.

For most Americans, financial experts recommend automatically contributing to an employer-sponsored 401(k) and an IRA. That's right — it's not an "either, or" situation; it's "both, and." 

While the taxation of these retirement accounts is objectively good, they do have slight variations that are important to consider.

Generally, 401(k)s and IRAs come in two types: traditional or Roth. Both types come with tax-advantaged features and annual contribution limits, but because there are very few situations where you can avoid taxes completely, the only difference between the two is when your money is taxed.

Distributions from Roth accounts are tax-free, while distributions from traditional accounts are taxed as income — basically, if you don't pay taxes now, you'll pay later, and vice versa.

We explore your options below. 

IRA versus 401(k): The biggest differences

How an IRA works

Traditional IRAs are tax-advantaged retirement savings plans that anyone can set up through brokerages and other financial institutions. You'll have way more investment options to choose from in an IRA, which may be enough incentive to open one.

You can only qualify for an IRA contribution deduction (which serves to lower your taxable income) if you meet the income limits, as well as the rules regarding whether you or your spouse also contribute to a workplace retirement plan.

Roth IRAs

And then there are Roth IRAs. These retirement accounts resemble traditional IRAs in that both include contribution limits and early withdrawal options. The distinction, though, is that contributions for Roth IRAs aren't tax deductible.

This means you won't have to pay taxes on the withdrawals you make later on. This is because you'll be paying upfront taxes on the contributions you make. Another difference is that Roth IRAs don't have minimum distribution requirements.

Roth and traditional IRAs still have some things in common, particularly income limits. For traditional IRAs, you can make full contributions as long as your income is less than $65,000 (single filers) or $104,000 (joint filers). For Roth IRAs, single filers can contribute if they make less than $124,000. The Roth IRA income limit for married filers is $196,000.

The investment options available in IRAs are the same whether the account is a traditional or Roth, so deciding which one to utilize will probably come down to whether you meet the income threshold and in what matter you want to save on taxes.

How a 401(k) works

Only offered by employers, traditional 401(k)s allow you to contribute a percentage of your paycheck into an individual account without paying taxes upfront. You'll only pay taxes when you withdraw the account's funds (you can withdraw money as early as age 59 ½). These retirement accounts offer another popular feature – the employer match. 

Some employers will match a portion of your annual contributions, up to a maximum percentage of your salary. For instance, if you make $50,000 a year and your employer provides a 100% matching benefit of up to 3% of your annual salary, your employer will give you $1,500 per year.

And any deposits you make are pre-tax contributions unless, however, you choose a Roth 401(k).

How a Roth 401(k) works

While few companies currently offer a Roth 401(k) option, it's becoming increasingly popular. The Roth provision basically reverses the rules — you'll contribute after-tax salary into your 401(k) and be able to withdraw your money tax-free at age 59 and a half.

Whether you go with a Roth 401(k) or a traditional 401(k) — assuming you have a choice — may come down to your marginal tax rate. If you expect to be in a higher tax bracket when you retire than you are currently, you may want to pay taxes now and contribute after-tax dollars to your account.

It's also worth noting that the 2020 annual contribution limit for 401(k)s is $19,500.

How to decide between an IRA and 401(k)

If you're thinking of opening a 401(k) and/or an IRA, it's important to consider the following factors before making a final decision:

  • 401(k)s are employer-sponsored retirement vehicles; IRAs can be opened by anyone.
  • Roth IRAs and Roth 401(k)s allow for after-tax contributions; traditional IRAs and 401(k)s are funded with pre-tax dollars.
  • Your tax bracket greatly affects how much you'll pay for contributing to or withdrawing from your retirement account.
  • The maximum annual contribution limit for 401(k)s is $19,500; for IRAs, the annual contribution limits are $6,000 (filers under 50) and $7,000 (filers 50 or older).
  • You can open both a 401(k) and an IRA, but this may affect the contributions you're allowed to make.

A traditional IRA could be a good fit for you if you prefer tax-deductible contributions and access to a large selection of investments. If you're not eligible for tax deductions, and you'd like to make tax-free withdrawals in retirement, a Roth IRA could be a suitable choice.

If you want higher contribution limits and potential employer matches, you should consider opening a 401(k). As with IRAs, you'll have two 401(k) account options: pre-tax or after-tax. 

If you don't mind paying taxes when you withdraw your earnings later in life, a traditional 401(k) could be a good option. A Roth 401(k) is worth considering if you'd rather pay taxes immediately.

Remember that you'll also have the option to open both an IRA and a 401(k). 

It's wise to think long-term when comparing retirement savings accounts. The eligibility requirements vary for each, and your income can directly impact how much you're able to save.

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