When saving for retirement, deciding where to keep your money is just as important as figuring out how much to set aside. Depending on where you work, your options might include a 401(k) plan. You could also stash retirement funds in a regular savings account. Understanding the differences between a 401(k) vs. savings account can help you to decide which one makes the most sense for your financial plan. You can also work with a financial advisor to help you create financial goals or help you match your investments to those goals.
What Is a 401(k)?
A 401(k) plan is a tax-advantaged plan that employers can offer to help employees save for retirement. Traditional 401(k) plans allow you to contribute pre-tax dollars and those contributions help to reduce your taxable income for the year. These plans are funded through elective salary deferrals, with the money you contribute coming straight out of your paycheck.
Employers can make matching contributions to employee 401(k) plans, though not all companies do this. If an employer offers a match, there’s usually a cap on the amount. For instance, your employer might match 50% or 100% of your contributions each year, up to 6% of your salary. That’s essentially free money you can get just for saving in your employer’s plan.
You can withdraw money in your 401(k) without a penalty once you turn 59 ½. Any qualified withdrawals you make from a traditional 401(k) are taxed at your ordinary income tax rate. Early withdrawals may be subject to a 10% tax penalty. Once you turn 72, you’re required to take minimum distributions from your plan, unless you’re still working. RMDs are based on your account balance and life expectancy and failing to take them on time can result in a tax penalty.
What Is a Savings Account?
A savings account is a deposit account that allows you to add money and earn interest on your balance. You can open savings accounts at traditional banks, online banks or credit unions. The rate you earn on savings and the fees you’ll pay can depend on where you bank. Online banks tend to offer the best combination of high rates and low fees.
Savings accounts allow you to withdraw money as needed, though withdrawals are not unlimited. Federal regulations no longer limit you to six withdrawals per month but banks can still impose that limit. If you make more than six withdrawals in a month, the bank can charge you an excess withdrawal fee.
You may need to meet a minimum initial deposit requirement to open a savings account. There may also be minimum balance requirements in order to avoid a monthly maintenance fee. You can link a savings account to a checking account for convenient transfers. Some banks also offer complimentary ATM cards with savings accounts.
401(k) vs. Savings Account: What’s the Difference?
A 401(k) is a tax-advantaged plan that’s designed specifically for retirement savings. The IRS regulates 401(k) plans and sets the rules for who can contribute and how much. The IRS also determines the tax treatment of both contributions and withdrawals.
The money you put into a 401(k) can be invested in mutual funds, exchange-traded funds (ETFs) and other investments. Contributions to a traditional 401(k) grow on a tax-deferred basis, meaning you only pay tax on earnings when you begin taking distributions. The value of your 401(k) can go up or down over time, based on the performance of your investments.
Some employers may offer a Roth 401(k) option, alongside traditional plans. With a Roth 401(k), contributions are made using after-tax dollars. That means you won’t pay tax on qualified distributions in retirement. You may, however, still face tax penalties for early withdrawals before age 59 ½. Unlike Roth IRAs, Roth 401(k) accounts are subject to RMD rules.
Savings accounts don’t offer any tax benefits, nor do they have the same potential for growth. Instead, a savings account is intended to be a safe, secure place to keep your money until you need to spend it. Savings accounts at FDIC-member banks are protected up to the standard coverage limit of $250,000 per depositor, per account ownership type, per financial institution. The National Credit Union Administration extends similar coverage to savings accounts held at member credit unions.
You make deposits to a savings account at your own pace and there’s no limit on how much you can deposit. You can withdraw money from a savings account up to the allowed number of times per month, without any tax penalties.
401(k) vs. Savings Account: Which One Do You Need?
The best account for your money is going to depend on your financial goals and overall plan for retirement. A 401(k) can help you to save money for retirement while enjoying some tax breaks. If you have access to a 401(k) at work, taking advantage of it can be a smart move. Regular contributions to a tax-advantaged retirement plan, even in smaller amounts, can add up over time through the power of compounding interest.
For 2022, you can contribute up to $20,500 to a 401(k) plan. You can also make an additional catch-up contribution of $6,500 if you’re age 50 or older. If you’re able to max out your plan each year and max out the company match, you could save a significant amount of money toward your retirement goals.
Again, you typically cannot withdraw money before age 59 ½ without a tax penalty. You can, however, avoid the penalty using the rule of 55. That rule allows you to take early distributions from a 401(k) penalty-free if you leave your job during the year you turn 55.
Savings accounts can be used for retirement savings but they’re typically better suited for other financial goals. For example, you might use a high-yield savings account to hold your emergency fund. If you have an unexpected expense, you can withdraw or transfer funds as needed. You may also use a savings account for other goals, such as planning a vacation, saving for a new car or preparing for a wedding.
The good news is that you don’t have to choose between a 401(k) vs. savings account. You can have both and use them to build financial security in different ways. Your 401(k) can be earmarked for retirement while you can add money to a savings account to fund other goals.
The Bottom Line
A 401(k) plan can be a powerful tool for building wealth and the sooner you start saving, the more time you have to capitalize on compounding interest. A savings account, meanwhile, can offer liquidity and flexibility. Knowing how they’re fundamentally different and what they’re designed to do can make it easier to determine where they fit into your financial plan.
Tips for Retirement
Consider talking to your financial advisor about how to make the most of your 401(k) if you have one and the best ways to use savings accounts. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you have a 401(k), it can be helpful to review your plan annually to ensure that you’re on track with your retirement goals. For example, you may need or want to increase your contribution rate or change up your investments to try to boost returns. It’s also important to consider the fees you’re paying for your 401(k). Excessive 401(k) fees can detract from your returns so it may be worthwhile to shift into lower-fee investments.
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