Nowadays, it’s no secret that there is much financial uncertainty in the markets. Investors monitor their portfolios on a daily basis to make the most logical finance decisions. After all, it is this money that will hopefully one day allow an investor to retire at a desirable age. Unfortunately, many people do not understand the investment options that are available. Generally, the two best options are a 401(k) and IRA (individual retirement account). There are differences and similarities between the two, which will be discussed below.
Let’s start with the 401(k). The term actually refers to the Internal Revenue Code section that defines the plan. Basically, it is a qualified profit-sharing plan that allows an employee to contribute a portion of their wages to individual accounts. There are actually two parties that benefit under a 401(k) plan: the employer and the employee.
First and foremost, it is important to realize that the employer must offer a 401(k) plan as an employee benefit. Not all employers offer this employee benefit, so don’t assume that this option is available for you. If it is offered, the employee determines how much he/she wants contributed to the plan each paycheck. The employer can then match some of those contributions, depending on the terms of the agreement. For instance, an employer may match up to 25% of an employee’s contribution, with 5% of the employee’s total salary serving as the maximum that will be matched.
When the employer matches a contribution, it is tax-deductible (to the employer). As far as the benefits for the employee are concerned, he/she can watch the capital in the 401(k) plan appreciate, tax-free, over time. In other words, any earnings that accumulate while the capital remains in the 401(k) plan are not taxable. However, once one receives a distribution from the plan, the amount may be subject to tax.
In contrast to a 401(k) plan, an IRA or individual retirement account is another option. Under this investment savings plan, one basically contributes money to a fund and then receives distributions at a later date. Specifically, it is a trust account in which one receives annuity payments (or sometimes variable payments) at a later date. There are two specific types of IRA accounts: a Roth IRA and a Traditional IRA. A Roth IRA is usually the preferred choice, as it offers tax advantages upon distribution. For example, if one made a contribution to a Roth IRA, the contribution would have to be made with after-tax dollars. When the individual decides to start receiving distributions from the Roth IRA, they are received tax-free. The general idea is that taxes will increase in the future and an individual would rather pay taxes now and avoid them when they increase in the future.
The Traditional IRA is the exact opposite, as capital is invested into the account with pre-tax dollars and then later distributed after tax effects have been applied. As can be seen, there are several similarities between the two investment options, meaning an individual needs to analyze his/her financial needs to decide which investment strategy is most suitable.