Introduction

Planning for retirement is a crucial aspect of financial health, and choosing the right retirement account can make a significant difference in your future. In this article, we will explore the pros and cons of 401(k) accounts, when you should invest in one, and when it might be better to consider an IRA instead. For any mortgage service needs, feel free to call O1ne Mortgage at 213-732-3074.

Pros of 401(k)s

401(k)s Offer Tax Perks

One of the primary benefits of a 401(k) is its tax advantages. Contributions are made pretax, which reduces your taxable income. Additionally, your money grows tax-free until you withdraw it, allowing your investments to compound over time without the drag of annual taxes.

Your Employer Might Contribute to Your 401(k)

Many employers offer a 401(k) match, which is essentially free money for your retirement. For every dollar you contribute, your employer might match that contribution partially or fully, depending on the specifics of your plan. According to Fidelity Investments, the average employer 401(k) match is 4.8%.

It Can Put Retirement Saving on Autopilot

Contributions to a 401(k) are typically made through automatic payroll deductions. This means you can set a percentage of your earnings to be funneled directly into your 401(k) without having to think about it. This automated approach can make saving for retirement much easier.

Cons of 401(k)s

Withdrawals Count as Taxable Income

Since 401(k)s are funded with pretax dollars, you’ll be taxed on withdrawals you make in retirement. This could create a significant tax burden, especially if a 401(k) is your primary source of retirement income. Additionally, early withdrawals before age 59½ typically incur a 10% penalty.

401(k)s Have Contribution Limits

In 2024, the contribution limit for a 401(k) is $23,000, with an additional $7,500 allowed for those aged 50 and older. Exceeding these limits can result in double taxation on the extra contributions. These limits may not be sufficient to fully fund your retirement, especially if you start saving later in life.

You Have to Take Required Minimum Distributions

Once you turn 73, you must begin taking required minimum distributions (RMDs) from your 401(k). Failing to comply can result in a penalty of up to 25% of the amount not withdrawn. Your RMD amount will depend on your 401(k) balance and a life expectancy factor determined by the IRS.

When Should You Invest in a 401(k)?

A 401(k) can be a powerful tool for retirement savings, especially if your employer offers a match. Here are some scenarios where it might make sense to invest in a 401(k):

• You have an employer match: If your employer offers this benefit, consider maximizing your match before investing in other accounts.
• You prefer a hands-off investing method: A 401(k) can be structured as a set-it-and-forget-it account, often with options like target-date funds that automatically rebalance.
• You want to reduce your taxable income: Contributions are made pretax, reducing your taxable income during your working years.

When to Consider an IRA Instead

An Individual Retirement Account (IRA) offers different benefits and may be a better option in certain situations. There are two main types of IRAs:

Traditional IRA

Contributions to a Traditional IRA may be tax-deductible, and your investments grow tax-deferred. However, you’ll be taxed on withdrawals, and early withdrawals before age 59½ incur a 10% penalty. RMDs also apply.

Roth IRA

A Roth IRA is funded with after-tax dollars, meaning you can withdraw your contributions at any time without penalty or taxes. However, withdrawing gains before age 59½ and before the account is five years old may result in taxes and penalties.

You might opt for an IRA over a 401(k) if:

• You’re self-employed: or don’t have access to a workplace retirement plan.
• You want more control: over your investments and contributions.
• You want the tax benefits of a Roth account: but your employer doesn’t offer a Roth 401(k).
• Your workplace 401(k) has high fees: which can eat into your returns.

Keep in mind that IRAs have lower contribution limits. In 2024, you can contribute up to $7,000 across all your IRAs, or $8,000 if you’re 50 or older.

Can I Have a 401(k) and an IRA?

Yes, it’s possible to have both a 401(k) and an IRA. Contributing to both can provide income diversification in retirement, as Roth IRA distributions are tax-free. This strategy can help you manage your tax burden more effectively in retirement.

The Bottom Line

A 401(k) is an employer-sponsored, tax-friendly retirement account that can make it easier to save for the future, especially if your employer offers to match your contributions. However, it’s important to consider the tax implications, contribution limits, early withdrawal penalties, RMD requirements, and potential fees. Understanding how a 401(k) works can help you maximize your long-term savings.

For any mortgage service needs, contact O1ne Mortgage at 213-732-3074. Our team of experts is here to help you navigate your financial journey and secure your future.