401(k) vs IRA: Choosing the Right Savings Plan for Your Future

Just the other day, I was having a conversation with my 17-year old daughter about the importance of saving for retirement and I explained that the sooner she starts, the better.  She then started asking questions about how to save for retirement and where she should invest her savings that she wants to earmark toward her future.  That led me to do a deep dive into two popular retirement savings options: the 401(k) and the Roth IRA.   Both provide powerful tools for growing your savings, but they work in very different ways.  I also wanted to learn more about retirement savings options for self-employed individuals, so included a section on that below too.  For young adults in their late teens and early 20s, understanding the differences between these savings vehicles can help you make the best choice for your financial future. In this post, we’ll break down how each account works, list the pros and cons of each, and offer guidance on which might be right for you.

What is a 401(k)?

A 401(k) is a retirement savings plan offered by employers, allowing employees to contribute a portion of their paycheck pre-tax, meaning before taxes are deducted. Many employers offer a matching contribution, where they match your contributions up to a certain percentage—essentially free money to boost your retirement savings.

How it Works:

• Pre-tax contributions: The money you contribute to a 401(k) is deducted from your gross income, which reduces your taxable income for the year. You won’t pay taxes on that money until you withdraw it during retirement.
• Employer matching: If your employer offers matching contributions, they’ll contribute additional money into your 401(k) based on your own contributions.
• Investment growth: The funds in your 401(k) grow tax-deferred, meaning you don’t pay taxes on the earnings until you withdraw the money in retirement.
• Contribution limit: For 2024, the annual contribution limit is $22,500, with an additional $7,500 catch-up contribution allowed for those aged 50 and older.

What is a Roth IRA?

A Roth IRA is an individual retirement account that you open independently, not through an employer. Unlike a 401(k), you contribute money that’s already been taxed, but your withdrawals in retirement are tax-free, including any investment earnings.

How it Works:

• After-tax contributions: The money you contribute to a Roth IRA comes from your post-tax income, so you don’t get a tax deduction upfront like with a 401(k). However, withdrawals in retirement are tax-free.
• No employer matching: Since this account is not tied to your employer, there’s no option for an employer match.
• Investment growth: All growth in your Roth IRA is tax-free, as long as you follow the withdrawal rules.
• Contribution limit: For 2024, the annual contribution limit for a Roth IRA is $6,500, with an additional $1,000 allowed for those 50 and older.
• Income limits: There are income limits that restrict higher earners from contributing to a Roth IRA. For 2024, you must have a modified adjusted gross income (MAGI) below $153,000 for single filers to contribute the full amount.

Comparing the Two: Pros and Cons

Now that you understand the basics of each account, let’s break down the key pros and cons to help you decide which is the best fit for you.

401(k) Pros:

1. Employer Match: Many employers offer a matching contribution, which can significantly boost your savings.
2. Higher Contribution Limit: The 401(k) allows you to save much more each year compared to a Roth IRA.
3. Lower Taxable Income: Because contributions are made pre-tax, they lower your taxable income for the year, which could help you pay less in taxes now.
4. Automatic Payroll Deductions: Contributions are taken directly from your paycheck, making it easy to save without even thinking about it.
5. Loan Options: Some 401(k) plans allow you to borrow from your account balance, though this is not generally recommended unless absolutely necessary.

401(k) Cons:

1. Taxes in Retirement: You’ll owe taxes on every dollar you withdraw in retirement, which can be a big financial burden depending on your future tax bracket.
2. Limited Investment Options: You’re limited to the investment options chosen by your plan administrator, which may not always be the best-performing or lowest-cost choices.
3. Required Minimum Distributions (RMDs): Once you reach age 73 (as of 2024), you are required to start taking withdrawals from your 401(k), whether you need the money or not.
4. Penalties for Early Withdrawals: Withdrawing funds before age 59½ generally results in a 10% penalty on top of taxes owed.

Roth IRA Pros:

1. Tax-Free Withdrawals: In retirement, your withdrawals are completely tax-free, which can give you peace of mind about future tax rates.
2. No RMDs: Unlike a 401(k), Roth IRAs do not require you to start taking distributions at any age, allowing your savings to grow longer.
3. Flexible Withdrawals: You can withdraw your contributions (but not earnings) from a Roth IRA at any time without penalties or taxes, which can be useful in case of an emergency.
4. Wider Investment Choices: Since you manage the account yourself, you have a broader range of investment options, such as individual stocks, bonds, mutual funds, and ETFs.

Roth IRA Cons:

1. Lower Contribution Limit: The contribution limit is much lower compared to a 401(k), which could limit how much you can save each year.
2. No Employer Match: Since a Roth IRA is an individual account, you won’t benefit from employer matching contributions.
3. No Immediate Tax Break: You don’t get an upfront tax deduction for your contributions, which could be a downside if you’re looking to lower your taxable income today.
4. Income Restrictions: Higher earners may not be able to contribute directly to a Roth IRA, or their contribution limit may be reduced.

Which is Best for You?

Deciding between a 401(k) and a Roth IRA largely depends on your personal financial situation and long-term goals. Here’s a breakdown of factors to consider for young adults in their early 20s:

If You’re Early in Your Career:

• Consider a Roth IRA. Since you’re likely in a lower tax bracket now than you will be in retirement, contributing to a Roth IRA means you pay taxes now while your income (and therefore, tax rate) is lower. Then, in retirement, your withdrawals will be tax-free.

If You Have Access to a 401(k) with Employer Matching:

• Take advantage of the match. It’s essentially free money, and the boost to your retirement savings is hard to pass up. If your employer offers a match, try to contribute enough to your 401(k) to get the full match before looking at other options.

If You Want More Flexibility:

• Roth IRA may be a better fit. With a Roth IRA, you have more control over your investments and can withdraw your contributions without penalty at any time. This makes it a more flexible option in case of emergencies.

If You Want to Maximize Savings:

• Combine Both. If you’re in a position to do so, you can contribute to both a 401(k) and a Roth IRA. Maximize your 401(k) contributions to get the employer match, then contribute to a Roth IRA for tax-free growth and flexibility.

Retirement Savings Options for Self-Employed Individuals

If you’re self-employed, whether you’re running your own business or working as a freelancer, you might not have access to traditional employer-sponsored retirement plans like a 401(k). However, you still have several excellent options for building a retirement nest egg. In fact, self-employed individuals often have more flexibility in choosing how much they can save and invest for the future.

Solo 401(k)

A Solo 401(k), also known as an individual 401(k), is designed specifically for self-employed individuals with no full-time employees (other than a spouse). This plan functions much like a traditional 401(k) and offers the benefit of both employer and employee contributions. As the employee, you can contribute up to $22,500 (or $30,000 if you’re 50 or older) in 2024. Additionally, as the employer, you can contribute up to 25% of your net earnings, allowing for a potentially higher total contribution. For self-employed individuals looking to maximize their retirement savings, the Solo 401(k) is a powerful option, especially with the potential for tax-deferred growth.

SEP IRA

A Simplified Employee Pension (SEP) IRA is another popular choice for self-employed individuals or small business owners. This account allows you to contribute up to 25% of your net earnings, with a maximum contribution limit of $66,000 in 2024. The SEP IRA is easy to set up and manage, making it a great choice for freelancers or business owners with variable incomes. Contributions are tax-deductible, and the account grows tax-deferred, which means you won’t pay taxes until you start making withdrawals in retirement. Unlike the Solo 401(k), the SEP IRA does not have a separate employee contribution; all contributions are considered “employer” contributions.

SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is another option for self-employed individuals or small business owners with fewer than 100 employees. This plan allows both employer and employee contributions, though the contribution limits are lower than a Solo 401(k) or SEP IRA. In 2024, you can contribute up to $15,500 as an employee, with an additional $3,500 catch-up contribution for those 50 and older. Employers must either match employee contributions dollar-for-dollar up to 3% of compensation or contribute a flat 2% of compensation, even if the employee does not contribute.

Conclusion

Whether you’re working for an employer or self-employed, building a retirement savings strategy early on is crucial for financial security. For young adults in their early 20s, deciding between a 401(k) and a Roth IRA often comes down to factors like employer matching, tax considerations, and flexibility. A 401(k) is a great option if your employer offers a match, providing a significant boost to your savings, while a Roth IRA can be ideal for those in lower tax brackets who want tax-free withdrawals in retirement.

For those who are self-employed, retirement savings may seem daunting, but you have access to powerful tools like the Solo 401(k), SEP IRA, and SIMPLE IRA. These options allow you to save aggressively, reduce your taxable income, and prepare for your future, even without the backing of an employer-sponsored plan.

Ultimately, the best approach may be a combination of these accounts, maximizing your savings across different vehicles for both tax benefits and long-term flexibility. Starting early and contributing regularly, whether through a 401(k), Roth IRA, or self-employed plan, will set you on the path to financial independence and a secure retirement.