401(k) vs IRA: How to Save for Retirement

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Retirement is likely the most prominent savings goal of your life. 

A recent study by Charles Schwab found that 401(k) plan participants anticipated needing $1.9 million dollars to live a comfortable retirement life. 

  • But where should you start? 
  • Which accounts will be best for you long-term? 
  • How much should you be saving?

With so many paths to choose from, how can you create a strategic retirement savings plan that mindfully helps you reach your goals?

Let’s focus on the top two retirement savings vehicles: 401(k) and IRA. To have a better understanding and context, it may be helpful to initially explore the broader picture of retirement savings in America.

The Pandemic’s Effect on U.S. Retirement Saving

Retirement saving is an inherently personal journey. 

So personal, in fact, that a significant part of your retirement income will come from personal investments via a 401(k), IRA, Roth accounts, HSA, brokerage accounts, and other investments earmarked for your golden years. 

This emphasis on personal savings has left many woefully behind on their retirement trajectory. Compounded by devastating job loss and economic hardship throughout the COVID-19 pandemic, what is the current state of retirement savings in the U.S.?

According to data from the 2021 Northwest Mutual Planning and Progress Study, not as discouraging as imagined. 

Their research found that 31% of Americans claimed improved financial discipline throughout the pandemic, and 95% plan to maintain their newfound good habits. 

Healthy habits like paying down debt, regular investing, and reduced discretionary spending were among the top-cited. It’s plausible these habits could remain given 83% of people were inspired to create or adjust their financial plans, emphasizing long-term financial wellness. 

That’s not all. 

Retirement savings increased 13% last year, with personal savings not far behind at 10%.

Increased retirement savings across the country is great news! So, how can you save for retirement smartly?

What is a 401(k)?

401(k)s are perhaps the most widely recognized and accessible retirement investment vehicles. 

The Bureau of Labor Statistics found 67% of people in private industry had access to employer-provided retirement plans in 2020 — and over 50% were defined contribution plans like a 401(k).

A 401(k) is a tax-advantaged, defined contribution retirement plan that allows employees to defer a portion of their salary. Below is a 401(k) snapshot:

  • You make pre-tax contributions based on a percentage of your paycheck
  • Investment earnings grow tax-free
  • Retirement distributions are taxed as ordinary income

In 2021, you can contribute up to $19,500 with an extra $6,500 in catch-up contributions for those over 50. Some companies also match employee contributions up to a certain percentage. 

Automating your 401(k) contributions to include your salary, bonuses, commissions, or extra payments is an excellent way to invest consistently. 

Tips to Enhance Your 401(k)

There are many ways to make the most of your 401(k). Below are a few ideas to consider. 

Maximize Your Company Match

The full burden of retirement savings may not fall entirely on your shoulders. Many larger companies offer a 401(k) match, where they match your contributions up to a specific limit — the average hovers at 4.3%

If you have access to a company match, take it! It is essentially free money and can help ease the personal burden of retirement savings.

Say your employer matches dollar for dollar up to 6%. You need to defer at least 6% of your salary to take advantage of the entire match. As much as retirement savings rely on your personal contributions, take advantage of any “free” money that’s available. 

Consider After-Tax Contributions

Already maxing out your 401(k)?

Check to see if your plan administrator allows after-tax contributions. While you’ll have to pay taxes at the outset, it could be an excellent way to boost savings in high-income years. 

Keep in mind the total 401(k) plan contribution limit is $58,000 (or $64,500 with catch-ups) in 2021. This figure includes money from your employer and after-tax contributions. 

Contribute to a Roth 401(k)

Roth accounts can be highly effective long-term savings avenues. You fund a Roth 401(k) with after-tax dollars, the investments grow tax-free, and retirement distributions remain tax-free. 

While you must pay attention to future required minimum distributions (RMDs), the withdrawals won’t increase your taxable income — a substantial win in retirement!

Increase Contributions as You Earn More

Did you just earn an enviable  raise? 

Consider funneling some of that extra money into your retirement account, at least until you’re maxing it out. Once you do that, turn your attention to other savings vehicles like putting extra funds in a brokerage account, HSA, or other savings avenue. 

Steadily increasing your savings as you earn more will help your retirement balance and protect you from lifestyle creep (living above your means). 

Choose Allocations Carefully (And Don’t Forget to Rebalance)

Most 401(k) providers offer investors a selection of stock and bond mutual funds, exchange-traded funds (ETFs), target-date funds, and company stock. 

When you set up your account, you’ll choose different portfolio types like conservative, moderate, aggressive, or somewhere in between, which help determine the types of investments you purchase. An aggressive portfolio, for example, may be 85% concentrated in stocks and 15% bonds. In general, the more time your money remains invested in the market before you have to use it for retirement, the more risk you can afford to take. 

Remember, your asset allocation should closely align with your risk tolerance, time horizon, and investment goals. It’s also prudent to regularly rebalance your portfolio to ensure your investments remain in tune with your long-term vision.

What is an IRA?

An individual retirement account (IRA) is a tax-advantaged investment vehicle for retirement. While there are numerous types of IRAs, two general categories are:

  • Traditional IRA
  • Roth IRA

A traditional IRA operates similarly to a 401(k):

  • Tax-deductible contributions (under specific circumstances)
    • Those making over $76,000 filing single or $208,000 married filing jointly cannot take the deduction. These limits decrease for those covered by a retirement plan at work — also known as a 401(k). See where you fall here
  • Tax-free gains/earnings
  • Taxable distributions (ordinary income)

A Roth IRA functions like a Roth 401(k):

  • After-tax contributions
  • Gains and earnings grow tax-free
  • Qualified distributions remain tax-free

Roth IRAs also come with other stipulations, namely, income thresholds. For 2021, you can’t directly contribute to a Roth if your modified adjusted gross income exceeds $140,000 (if filing single) and $208,000 (if married filing jointly). 

High-earners can still take advantage of a Roth IRA by pursuing other strategies like Roth conversions or Mega Backdoor Roth IRAs. These strategies come with substantial tax and cash flow considerations, so consult your tax professional and advisor before taking action.

IRA contribution limits are significantly lower than 401(k)s — $6,000 with an extra $1,000 in catch-ups for 2021. The only way to bypass these contribution limits is with a rollover or conversion. 

Some 401(k) plans, for example, allow an in-service rollover to an IRA. This means  investors can transfer all or a portion of their account into an IRA even if they’re not changing jobs. 

The same idea applies to Roth conversions. You could convert well more than $6,000 from a traditional IRA into a Roth, assuming you have the cash to pay for the tax bill.

Tips to Enhance Your IRA

IRAs come with different planning opportunities. Below are ways you can make the most of this type of account. 

Automate Contributions

IRAs don’t have the same built-in automation as 401(k)s. Instead of just putting in money now and then, establish recurring investments such as $200 a month. Consistent monthly investing is a healthy habit to cultivate and can help ensure you’re being diligent about your retirement savings goal. 

Consolidate Old Accounts

People rarely stay at one company for their entire careers, which could leave your old 401(k)s in the lurch. Consolidating them into your IRA keeps your financial management manageable, reduces fees, and provides a clearer picture of your money.

Consider a Roth Conversion

A Roth conversion is a strategy that transfers funds from a traditional IRA into a Roth IRA. It’s a helpful  option for high-income earners to take advantage of Roth accounts. Since the conversion is considered income, this strategy is most suitable for lower-income years, so you don’t inadvertently bump yourself into a higher tax bracket. 

401(k) or IRA Which is More Advantageous?

401(k)s and IRAs offer investors many different benefits. Here’s a closer look at some of the main advantages one account has over another.

401(k)s Have Higher Contribution Limits (Some With a Match)

401(k)s allow for more significant annual contributions ($19,500 vs. $6,000). This account is a strong choice for building up retirement savings over time. 

No one is volunteering to help you fund an IRA — that’s all on you. With a 401(k), the employer has a chance to contribute. If your company offers this benefit, ensure you’re putting in enough to qualify for the full match. 

Another benefit of a 401(k) is the tax deduction. If you have a 401(k), odds are you won’t be able to deduct contributions to your traditional IRA. 

401(k) Funds are More Accessible Before Retirement

Most 401(k) providers offer loans you can access before age 59 ½. 

In 2020, the SECURE Act also approved penalty-free early withdrawals for COVID-related medical care (up to $100,000). 

Many plans come with hardship clauses that allow withdrawals for certain medical costs, funeral and end-of-life expenses, disability, or other personal hardships. 

For those looking to retire early, you may also be able to access funds as early as age 55 (assuming you’re fully retired).   

IRAs Have Broader Investment Selections

If your 401(k) is a staycation, then your IRA is an international getaway.

IRAs offer a much more diverse investment pool like stocks, bonds, ETFs, mutual funds, index funds, real estate investment trusts, and more. A more comprehensive selection affords better opportunities for investors to customize their portfolios to match their needs.

With an IRA, You Choose a Custodian

With a 401(k) plan, you’re stuck with the provider your company uses, which could lead to higher account management fees. An IRA gives you the flexibility to select a custodian of your choice. This means you can shop around for the best investment selections, low fees, and other elements that may be important to you, like tax planning or socially responsible investing. 

It’s also much simpler to provide your advisor management access to your IRA. With your 401(k), it’s nearly impossible to do.

Create an Investment Plan to Support Your Retirement Goals

Ultimately, both 401(k) and IRA can help you on your long savings journey to retirement. It’s meaningful to understand how these accounts work to take advantage of their unique properties.

At Abacus, we care about helping you set up an investment strategy that honors your distinctive retirement goals. Odds are that a 401(k) and an IRA will be a fundamental part of that plan. 

Ready to see how you can use both of these accounts to secure your future? 

Let’s talk about it together. 


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