Saving for early retirement is a financially and mentally freeing goal, yet somewhat complex at times when trying to select the best strategy. Throw in the lack of general education early on with financial literacy, combined with the plethora of resources available, it can be challenging to know where to start, and easy to inadvertently misunderstand or confuse the different retirement savings vehicles. For example, I occasionally will hear individuals reference an IRA as a 401(k) and vice versa, and not distinguish between a Roth 401(k) and regular Roth IRA.
Traditional 401(k)
A 401(k) is an account that allows you to contribute some of your salary on a pre-tax basis, meaning it is coming out of your paycheck prior to taxes being deducted. This contribution is usually based on a percentage of what you make, and your employer will typically match up to a certain percentage of what you earn. Compared to an IRA, this has a much higher overall contribution limit and is the most common retirement investment vehicle for most individuals.
Many 401(k) participants choose to utilize target date funds when selecting an investment for their 401k, and this may even be the default in cases of auto enrollment. These are most common in 401ks but can be purchases in IRAs and Roth IRAs as well.
Roth 401(k)
An employer may also offer a Roth 401(k) option. This has the same contribution limits as a traditional 401(k), but the employee contribution is After Tax, meaning there is no immediate deduction for that contribution, but the employer portion may still be pre-tax. Investment options like a pre-tax 401(k) are limited to what the plan/employer makes available.
The funds that you have available in your 401k usually do not differ between your Traditional 401k and Roth 401k.
IRA
An IRA is a savings vehicle in which you can contribute up to $7,000(2024) per year ($8,000 for those over 50). Similar to a brokerage account, these are established by the individual themselves and are not tied to an employer nor receive an employer matching contribution. Any contribution made to this account is tax-deductible dependent on whether or not you have a 401(k) and are actively making contributions. Most commonly, people tend to lean towards making contributions toward their 401(k) if available via their employer as it has higher limits.
Roth IRA
Similar to a Traditional IRA, a Roth IRA has the same annual limit of $7,000(2024). These types of accounts have gained popularity over the years as they do not require RMDs to begin, so any contributions invested can grow tax-free.
These can be a good option for having additional retirement savings beyond the 401{k} or if your employer requires employment for a certain period of time prior to allowing contributions to a 401(k). They are also pertinent for those who do not have an option to contribute to Roth 401k.
Common Misconceptions
Often I hear people refer to their IRAs and 401(k)s as the same account, when in fact they are similar but not necessarily the same. This confusion persists when referring to Roth IRAs and Roth 401(k)s as one in the same, when in technical terms they are different.
They can be easily confused as they have similarities between each other and differences. The below chart highlights some of the similarities and differences.
Contribution Limit | Employer Match | RMDs Required | Catch up contribution | Funds Available | Taxability | |
401(k) | $23,000 | X | X | $7,500 | Limited | Tax-Deferred |
Roth 401(k) | $23,000 | X | X (not required starting in 2024) | $7,500 | Limited | Taxed prior to contribution |
IRA | $7,000 | X | $1,000 | Broad Range of selection | Tax-Deferred | |
Roth IRA | $7,000 | $1,000 | Broad Range of selection | Taxed prior to contribution |
*2024 Data
Here are some additional differences between 401k and IRAs
Fund Availability
The fund selection varies depending on 401(k) vs IRA/Roth IRA. A 401k would offer a limited pool of mutual funds based on how the plan is set up whereas you would have a much larger pool of investments in a Roth IRA & IRA.
Employer Directed vs Self-Directed
401ks are set up through your employer once you have reached their eligibility requirements, usually by working a set period of time with the company. IRAs are set up directly by the individual, and the account holder themselves has the responsibility for investing the funds they contribute to IRAs and Roth IRAs.
Different rules for early withdrawals and RMDs
401(k)s have some slight differences in taxability of withdrawals, but also have additional ways to access funds prior to age 59.5. Working past age 55 and retiring would allow you to make withdrawals from your 401k right away for example, which is not a characteristic in an IRA.
Below are two similarities:
Tax Free Growth
The investments you own within 401ks and IRAs, regardless if they are Traditional or Pre-Tax are not taxed. Meaning any dividends from investments or selling an investment for a gain within these accounts is not taxed.
The purpose of these accounts
All 4 types of accounts share a common goal. Long term savings to cover expenses for when you reduce or eliminate working hours. This is one of the main reasons penalties are in place to disincentivize people from removing the funds until later on. The benefit mentioned in the prior point over the long run can be substantial if you begin investing in retirement accounts earlier.
What makes sense for me?
Your personal goals for retirement and when/how you wish to spend down what you have saved will determine how you should invest. Ultimately, what you save in these accounts will be used for spending purposes or given away during or after your lifetime.
Secondly, determining a good mix based on how much you pay on taxes when you contribute to your retirement accounts will make a decent impact on how much you save. Typically, when your income is relatively higher it makes more sense to utilize a pre-tax 401k or IRA account and a Roth 401k/Roth IRA when your income is lower, but this may vary depending on your unique circumstances.
How do I select investments for each account type?
You typically will have a limited list of funds available to you in 401(k) account to select from, and oftentimes a target date fund is used, which has a combination of stocks and bonds that reflect a proper allocation for a specific retirement year. If you have a goal of retiring early and follow the FIRE movement, you will want to be conscientious about simply selecting a target date fund, as it may not fully align with your goals.
Appropriate Saving and disciplined investing in a tax-advantaged manner in any of these accounts will help mitigate the challenges of retirement, even if you opt for a non-traditional mode of retirement. Understanding the key differences will help you better plan tax efficiently as well.
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