As with other major financial matters in your life, it pays to do your homework as you plan for retirement.
And part of that is understanding the differences between a 401(k) plan and a Roth IRA, two methods for maximizing your savings during your working years.
Sounds boring? Get over that! Prioritizing retirement-saving is one of the best decisions you can make for your financial future. The younger you start, the more comfortable your finances will be when it's time to clock out of work for good.
Understanding 401(k) plans
A 401(k) is a retirement savings vehicle that's offered by employers. So pay attention at work, because if you have a chance to sign up, you won't want to miss out.
You decide how much of your pay you want to contribute, typically a percentage of your salary.
Your employer will transfer the money into the account before any taxes are withheld, and your savings are invested, most often in mutual funds made up of stocks and bonds. It's fun to watch how your money grows!
(Even more fun: Blooom is an independent robo-advisor specializing in managing 401ks, and we can't recommend it enough. If you're ready to up your retirement savings game, get your free analysis with Blooom today.)
Contributions to the plan throughout the year lower your taxable income, and some employers even match what you put in — up to a point.
While there are limits on how much you can contribute each year, a 401(k) is a pretty painless way of saving for retirement that makes it difficult for you to spend the money you've set aside.
Take the money out early and you'll have to pay taxes, plus you may face a 10% penalty. "Early" means before age 59 1/2. Could they have made it more random? After you've reached that age, the withdrawals are taxed as regular income.
How a Roth IRA is different
A Roth IRA (individual retirement account) is similar to a 401(k), though with the taxes flipped.
You put part of your income into the account after taxes have been taken out, and you pay no tax when you withdraw the money in retirement, not even on your investment earnings.
This account can contain a variety of investments including mutual funds, bonds, stocks, securities and even certificates of deposit (CDs), just to name a few. As with a 401(k), a savings cap is applied on an annual basis.
If you really want your Roth IRA to feel like a 401(k), you can set up automatic contributions from your paycheck through direct deposit.
You're eligible to save in a Roth IRA only if your income (either individual, or joint if you're married) is below a certain threshold. The limits change each year and can be found on the IRS website.
Similar to a 401(k), you may face a stiff, 10% penalty if you make early withdrawals from the account's earnings (though not your contributions). Again, "early" means before age 59 1/2.
The bottom line
When it comes to deciding what type of retirement savings plan is better for you, take the proper time to consider the pros and cons of each type — especially the taxes — and make the choice that fits your financial situation and your goals.