Maximum IRA Account Contributions vs. a 401(k) Plan

When small business owners are thinking through whether to start saving for retirement for themselves or to set up a retirement plan for both themselves and their employees, they are typically deciding between the two more popular retirement options – an IRA of a 401(k) plan. Both of these accounts offer tax advantages to save for your future.

What is an IRA?

An IRA is an individual retirement account that allows you to make tax-deductible contributions, potentially reducing your current taxable income. IRAs have annual contribution limits, which can change over time based on tax laws and inflation. These limits are set by the IRS. There can be restrictions if you can contribute to an IRA if your spouse has access to a workplace retirement plan, or you may earn too much to take advantage of a Roth IRA. Additionally, there are rules governing when and how you can withdraw funds from an IRA to ensure that they are primarily used for retirement purposes.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement savings plan that helps employees and business owners alike contribute to retirement. 401(k) plans are a popular retirement plan for businesses and employees because they offer flexibility, automatic payroll contributions, high contribution limits, and tax benefits. There are Solo 401(k)s for the self-employed as well as 401(k)s designed for small businesses.

IRA Versus a 401(k)

There are some notable differences between IRAs and 401(k)s. Beyond one is a retail product and the other a business benefit, the biggest is that they have very different contribution limits. For example, you can only contribute up to $7,000 to an IRA for the 2024 tax year. On the other hand, an employee participating in a 401(k) plan can contribute up to $23,000 this year (or $30,500 if over age 50).

So, as you can see, the 401k plan provides much more saving power over an IRA. If you're self-employed and have access to a Solo 401(k),(hyperlink to solo 401k product page) you can also make employer contributions. That’s the beauty of being self-employed -- you are both the employee and employer. As an owner-only businesses, you can contribute up to $69,000 for the 2024 tax year (or $76,500 if over age 50) assuming you have the earnings to do so (there is a calculation –typically 20%-25% of earnings can be contributed as an employer up to the limit). Of course, with a 401(k), you are managing a benefit for your business versus an IRA account is just for you.

^{*Beginning at $146K, the amount you are allowed to contribute begins to decrease, hitting $0 at $161K for singles (range is $230K to $240K for married couples filing jointly)}

IRA Tax Benefits

IRAs offer unique tax benefits that can be advantageous for retirement planning:

Traditional IRA contributions are typically tax-deductible, reducing your taxable income for the year in which you contribute.

This tax deduction can lower your current tax bill, potentially freeing up more funds for retirement savings.

In contrast, Roth IRAs don't provide an immediate tax deduction, but they offer the benefit of tax-free withdrawals in retirement, providing valuable tax diversification for your retirement portfolio.

Understanding the tax benefits associated with IRAs is essential for making informed decisions about your retirement savings strategy. Consider consulting a financial advisor to determine which type of IRA aligns best with your financial goals and tax situation.

What is a Rollover IRA?

A Rollover IRA is typically used to consolidate funds from a previous employer's retirement plan, such as a 401(k), when changing jobs. It can be easier to keep track of your retirement savings and manage your investing strategy.

It allows you to maintain the tax-advantaged status of your retirement savings and continue to grow your investments.

A Rollover IRA is a type of a Traditional IRA or Roth IRA account that allows you to gain access to manage your old 401(k) or other retirement accounts.

Roth IRA vs a Roth 401(k)

While Roth IRAs and Roth 401(k)s share the Roth label, their tax rules differ significantly. The biggest difference again comes down to contribution limits. With an IRA, you can only contribute up to $7,000. On the other hand, an employee participating in a 401(k) plan can contribute up to $23,000 this year (or $30,500 if over age 50). Based on your earnings, you may not be able to even contribute to a Roth IRA, while a Roth 401(k) has no such restriction. It's essential to grasp these distinctions when considering your retirement savings strategy:

Roth 401(k):

Roth 401(k) contributions are made with after-tax dollars, meaning you don't receive an immediate tax deduction.

However, qualified withdrawals from a Roth 401(k), including investment gains, are entirely tax-free during retirement.

Roth IRA

Roth IRA contributions are also made with after-tax dollars, providing no upfront tax deduction. In 2024, the contribution limit is $7,000 (or $8,000 if you’re over age 50).

With a Roth IRA, like a Roth 401(k), all withdrawals, including investment gains, can be taken tax-free in retirement.

Beginning at $146K, the amount you are allowed to contribute to a Roth IRA begins to decrease, hitting $0 at $161K for singles (range is $230K to $240K for married couples filing jointly)

Choosing between a Roth 401(k) and a Roth IRA often depends on your employer's offerings, your earnings, and your individual financial circumstances.

Roth tax rules are the exact opposite of how traditional tax-deferred 401(k) contributions work. Your tax-deferred contributions will be taxed when you withdraw the money at retirement; however, you receive no tax deduction on Roth contributions. The benefit is that your Roth withdrawals (including investment gains) can be taken tax-free when you reach retirement.

Roth Conversion Rules

For individuals looking to optimize their retirement savings and tax strategy, Roth conversions can be a valuable tool. These conversions allow you to move funds from a traditional retirement account, such as a traditional IRA or 401(k), into a Roth account. Here are some key rules to keep in mind:

Roth conversions are taxable events, meaning you'll owe income tax on the converted amount in the year of the conversion.

However, once the funds are in a Roth account, they can grow tax-free, and qualified withdrawals in retirement are tax-free.

Conversions can be a strategic move, especially in years with lower income, as it can help manage your future tax liability.

Why 401(k) May Be a Better Option

While IRAs offer valuable retirement savings options with their tax benefits and flexibility, 401(k) plans provide higher contribution limits and more flexibility, making them a better option for those who have the earnings to maximize their retirement savings. The ability to contribute as both the employee and employer can substantially increase your retirement nest egg. Of course, a 401(k) benefit does require some work to establish bi-weekly payroll if you have employees. The choice between an IRA and a 401(k) should align with your business needs, financial goals, income, and tax strategy. Consulting a financial advisor can help you make the best decision for your retirement planning needs.

Key Takeaways:

• IRAs (Individual Retirement Accounts) allow tax-deductible contributions, potentially reducing your taxable income, but have lower contribution limits, such as $7,000 for 2024 (or $8,000 if you're over 50).

• In contrast, 401(k) plans allow contributions of up to $69,000 in 2024 (or $76,500 if you're over 50), making them more powerful savings tools.

• IRAs offer unique tax benefits, such as tax-deductible contributions for Traditional IRAs and tax-free withdrawals in retirement for Roth IRAs, providing tax diversification for your retirement portfolio.

• Rollover IRAs are useful for consolidating funds from previous employer retirement plans while maintaining tax-advantaged status and investment growth.

• Roth IRAs and Roth 401(k)s have distinct tax rules, with Roth 401(k) contributions made with after-tax dollars and providing tax-free withdrawals in retirement. Roth IRAs offer similar benefits but have lower contribution limits.

• Roth conversions allow you to move funds from traditional retirement accounts to Roth accounts, but they are taxable events. However, once in a Roth account, funds can grow tax-free, offering tax management opportunities.

• While IRAs have their advantages, 401(k) plans, can be better options for those with higher earnings due to their significantly higher contribution limits, offering a substantial boost to retirement savings.

• Your choice between an IRA and a 401(k) should align with your business needs, financial goals, income, and tax strategy. Consulting a financial advisor can help you make informed decisions about your retirement planning.

This is not meant to be tax advice. ShareBuilder 401k does not offer tax or legal advice. Consult with your tax or legal advisor before engaging in specific strategies.

Please note that catch-up contributions for individuals aged 50 and over are additional and not included in the discussed contribution limits.