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Published: Nov 25, 2020 6 min read

Although it may be hard to think past the seemingly endless year that is 2020, it's a mistake to not save for the future. In order to take full advantage of compound interest and tax perks, you've got to plan ahead for retirement.

At work you may have access to a defined contribution plan like a 401(k) or 403(b). But a growing number of Americans with 401(k)s are also socking money away in Individual Retirement Accounts, according to a recent update from Fidelity Investments.

Do you need an IRA instead of — or in addition to — your 401(k)? Which is better? How should you choose?

Here's what to know.

There are big differences between 401(k)s and IRAs

Ubiquity Retirement + Savings’ Andrew Meadows points out one major distinction between 401(k)s and IRAs: The former is connected to your workplace, while the latter is not. (Hence the name.)

In his mind, 401(k)s are set up to benefit the employee, while IRAs are “purely investment vehicles.” The annual 401(k) contribution limit for 2021 is $19,500 compared to just $6,000 for IRAs.

“If you’re looking at starting an IRA, that’s good and wonderful, but you’re not going to save nearly as much,” he says.

And yes, you can have both. Having a 401(k) is nice because your company may offer to match funds you put away for retirement. That money also may come out of your paycheck before it appears in your checking account, preventing yourself from seeing — or spending — it before moving it to savings.

But IRAs have perks, too. If, for example, you want to quit and sever ties with your job but keep saving for retirement in a portable way, an IRA can be a useful place to roll over your 401(k). You can also use it to consolidate multiple 401(k)s from various jobs that may pile up over time. As Meadows puts it, IRAs tend to be “an independent and individual tool for people who want a little more freedom.”

So while the 401(k) is a more powerful savings plan, the IRA is a more flexible one.

You should maximize your work benefits first

Peter Hunt, a CFP and director of client services at Exencial Wealth Advisors in Oklahoma, says he actually recommends a “savings priority order” to young investors.

First, you should contribute to your 401(k) up to the amount that your employer matches. If you have income left over to save, then you should see if you're eligible for a Health Savings Account. Finally, if you have income left over after that, you should contribute to a Roth IRA.

Traditional 401(k)s and IRAs are pre-tax, so the contributions come out of your gross paycheck, and are tax-deferred, meaning you pay income taxes on them once you withdraw the funds. But with the Roth option, you pay taxes up front and then withdraw the money tax-free in retirement.

Plus, as long as you're taking out the contributions — not the earnings — there’s also no penalty. With traditional 401(k)s and IRAs, you have to pay income taxes plus a 10% penalty if you take out money before age 59 ½ outside of certain limited circumstances. (Usually. Right now there's an exception through the CARES Act.)

“The Roth IRA gives you a lot of flexibility,” Hunt adds. “You can pull contributions out at any time for any reason.”

Consider both retirement plans (and ask for help)

Meadows says there’s nothing wrong with maintaining a 401(k) at work and throwing $500 into a Roth IRA every quarter or time you get a raise. That way you're taking advantage of the compound interest as well as your full compensation benefits.

“The importance here is diversification," he says. "Don’t put all your eggs in one basket."

The bottom line? Because of the way 401(k)s are structured, you should always contribute up to the maximum your company matches for 401(k)s. But if that’s not an option for you, if you want to roll over funds or if you still have more money to save, opening a traditional or Roth IRA could be smart.

Jamie Ohl, executive vice president and president of retirement plan services for Lincoln Financial Group, says you don't necessarily have to make the decision on your own. Since it involves weighing the tax bracket you're currently in and the tax bracket you think you'll be in when you retire, it’s not a bad idea to get advice from a financial advisor.

“Ensure that you are educated on your options and how you can maximize them,” Ohl says.


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