Retirement accounts offer specific tax benefits
Retirement accounts can be opened individually or through your employer
401k and IRA accounts offer two main types of tax advantages
A retirement account is a type of investment account that provides tax advantages a normal investment account does not. With a regular investment account, you pay taxes whenever you sell a holding, which can eat away at your long-term returns. Because you pay taxes on your retirement investments either all up front, i.e. Roth accounts, or when you retire, i.e. Traditional accounts, you don't pay taxes every time you sell an investment in your retirement account. The money saved on taxes in retirement accounts can often add to your returns in the long run.
- Retirement investment accounts help create long-term wealth and can help you save on taxes.
- These tax-advantaged accounts entail withdrawal limits. If you withdraw from your retirement account early, you may owe taxes and a penalty.
- A 401k is a retirement account offered through your employer. An IRA is a retirement account that you can open as an individual and does not require an employer.
- Roth IRA accounts allow for more flexible withdrawals than traditional IRAs, but Roth IRA income restrictions limit who is eligible.
Retirement accounts come with tax advantages that help you build wealth over the long term. However, the tax benefit comes with some restrictions. If you decide to withdraw money before you reach retirement age, you may pay a penalty fee. There are also limits on how much you can contribute in a year. Specific limits, tax advantages, and withdrawal restrictions depend on the type of the account. (You can find a full list of contribution and income limits here.)
The primary distinction between a 401k and an IRA is a 401k is offered through an employer whereas an IRA (Individual Retirement Account) is a retirement account you can open yourself.
- 401k accounts have higher contribution limits.
- IRAs provide greater flexibility and autonomy over your investments. As your 401k is managed by your employer, your employer may limit the investments funds available to choose from. 401k accounts may also entail higher fees.
- 401k accounts may offer a contribution match from your employer. These contributions do not count towards your yearly limit but may cap based on your income.
What are the differences between Roth and Traditional accounts?
If you see Roth and Traditional before your account type, this tells you what type of tax advantage your account offers.
- Traditional accounts are funded with pre-tax income. Roth accounts are funded with after-tax income, i.e. the money you see in your paycheck.
- A traditional account means your contribution is tax deductible the same calendar year and you pay taxes on the investments when you withdraw the funds. With a Roth IRA, you cannot deduct your contribution that year, but you will not pay taxes on the withdrawal.
- You can withdraw the amount you contributed to a Roth IRA, just not the investment gains, anytime without penalty. With a traditional IRA, an early withdrawal comes with a penalty.
- A Traditional IRA has no income restriction whereas a Roth IRA does.
Credit: Khan Academy
Credit: Khan Academy