If you think it's time to start socking money away for retirement, you may have considered opening a savings account with your local bank or credit union. Another option is to contribute to your 401k plan at work if your employer offers this as a fringe benefit. Each method presents a number of potential advantages and disadvantages.
A 401k allows you to invest pre-tax dollars, meaning your contributions will lower your taxable income for the years in which you make them. Your money also grows on a tax-deferred basis, so you won't pay taxes on the earnings until you begin to make withdrawals at retirement. With a regular savings account, the interest you earn is typically considered to be taxable income that you must report on your tax returns each year. While you will pay taxes on your 401k distributions, tax-deferral allows the account to grow faster than standard savings.
Many employers will match your contributions to your 401k up to a certain point. In essence, this is "free" money that can greatly enhance the value of your account as the years go by. In time, you will become fully vested in the plan, meaning you will own the full amount of your employer's matching contributions. Savings accounts do not offer a matching feature, meaning your contributions are the account's only source of funding.
401k plans usually feature a variety of investment types, such as stocks, bonds and money market accounts. This allows you to diversify your money within a single investment vehicle, and you can rebalance your portfolio to adjust to changing economic conditions. A typical bank savings account does not offer the ability to diversify.
Tied to Employer
With a 401k plan, your account is tied to your employer. If you leave the company, you typically need to roll the money into your new employer's 401k or an IRA within 60 days to avoid taxation and penalties. Some employers may permit you to keep your 401k with the company after you leave, although you probably won't be able to make future contributions. With a savings account, you enjoy greater freedom to move your money to another financial institution or investment. Federal law and your employer can also limit how much you can contribute to a 401k, while banks may allow you to deposit an unlimited amount.
Savings accounts offer the advantage of liquidity. If you need money quickly, it's usually a simple matter of going to the bank and making a withdrawal. With a 401k, you normally cannot make withdrawals prior to the age of 59 1/2 without incurring a 10 percent penalty, and you'll be taxed on the withdrawn amount. Many 401k plans include a loan provision, but you must repay the money plus interest within five years to avoid penalties and taxation.
The upside of a 401k plan can be greater than that of a savings account due to factors such as the potentially high return on investments, like stocks and bonds, over time, as well as the additional contributions from the employer match. On the other hand, savings accounts often feature a guaranteed rate of return, and the Federal Deposit Insurance Corporation insures deposits up to $250,000. Some types of 401k investments offer little or no return guarantees.
- tax forms image by Chad McDermott from Fotolia.com