If you just received your first paycheck or managed to save some money, it's time to learn the basics of how to invest. We present you with two very different options: 401(k) vs savings account.
Should you stash that extra cash into your 401(k) or tuck it away in a savings account? Both options seem smart, but they serve different purposes. So, how do you choose? Let’s break it down together.
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401(k) vs savings account: what's the difference?
A 401(k) is a retirement savings plan offered by many companies, which allows employees to save and invest a portion of their paycheck before taxes are taken out (additionally, your employer will probably match your contributions, up to a certain amount.)
It’s an investment account designed for long-term growth, making it a solid choice for those focused on saving for retirement. Think of a 401(k) as a long-term commitment—it’s like planting a tree that you can’t enjoy until it’s fully grown. The goal here is to let that money grow over time so you have a nice amount when you retire.
On the other hand, a savings account is a more flexible, accessible way to set aside money for short-term goals or emergencies. While a 401(k) is specifically for retirement, a savings account can be used for any purpose—like a piggy bank that’s easy to access whenever you need it. The trade-off? The interest it earns is usually pretty modest compared to what you might gain with a 401(k).
“Anyone can open a savings account, while a 401(k) is offered by an employer,” says Nicole Stanley, money coach and CEO of Arise Financial. “Savings accounts have lower interest rates, whereas the investments in a 401k will likely have higher returns based on stock market historic data.”
How does a 401(k) plan work?
A 401(k) plan is a retirement investment account. You contribute a portion of your salary to this account, and the money is invested in various assets like stocks, bonds, or mutual funds—which means it has the potential to grow significantly over the years. Many employers also match a percentage of what you contribute, which is like getting more money for free.
One of the key benefits of a 401(k) plan is that contributions are made pre-tax.“This means you set aside part of your pay before taxes,” Stanley says. “It lowers your taxable income, so you pay less income tax now.”
However, there are rules about when you can access the funds. Remember, this is a retirement fund, so the government doesn’t want you dipping into it too early. “This is an account reserved for long-term, buy-and-hold investing,” Stanley says. “These are funds for your future, not for your present.”
If you withdraw money before you turn 59½, you’ll owe taxes on it and face a 10% penalty. This is definitely a “set it and forget it” type of savings strategy meant to help you down the road.
If your employer does not offer a 401(k) or similar account, Stanley suggests a Roth IRA (Individual Retirement Account) as a good substitute, although it has different requirements and contribution limits.
“The 401k has a 2024 contribution limit of $23,000, with a $30,500 limit if you're age 50 or older, and a max of $69,000 for the combined employee and employer contributions,” he says. “A Roth IRA has a 2024 contribution limit of $7,000 for those under 50, and $8,000 for those 50 and older.”
How does a savings account work?
A savings account is a safe and low-risk place to park your money, which will earn a modest amount of interest over time. Unlike a 401(k) plan, savings accounts are easy to access, allowing you to withdraw money whenever you need it without penalties.
However, the interest rate on savings accounts is lower than the returns you might earn from investments in a 401(k). This means that while your money is safe, it’s not going to grow as quickly as it might in a 401(k). But that’s OK—because a savings account should be used for its liquidity and security, not long-term growth.
Is it better to have a savings account or a retirement account?
Why choose just one? Both a 401(k) and a savings account have their place in a financial strategy. “A savings account and a retirement account are two completely different accounts and you should have both,” Stanley says.
Contribute to your 401(k) to take advantage of tax benefits and employer matches, but also maintain a savings account for liquidity and emergencies. By diversifying your savings strategy, you can ensure that you’re prepared for both the short-term and long-term future.
Understanding how each works and when to use them can help you make the most of your money, ensuring that you’re ready for retirement while also being prepared for life’s unexpected twists and turns.
Saving account vs 401(k) FAQs
When to choose a 401(k)?
If your goal is to retire comfortably, a 401(k) is the way to go. Picture yourself in your 60s, living off the funds you’ve smartly invested over the decades. That’s the long-term future a 401(k) offers.
The tax advantages, potential employer match, and long-term growth make it a powerful tool for building a retirement nest egg. If your employer offers a match, it’s essentially free money, so it’s usually wise to contribute enough to get the full match.
When to opt for a savings account?
Savings accounts are ideal for short-term goals or an emergency fund. If you’re more concerned about the here and now—like having money on hand for unexpected expenses—a savings account is your friend.
“Putting your emergency fund in a savings account, preferably a high-yield savings account, is what it’s made for,” Stanley says. “You can also house short-term financial savings goals in a savings account. Think car down payment, vacation savings, home maintenance funds, etc.”
Since the money is easily accessible without penalties, it’s a safer place to keep funds you might need on short notice. If you’re saving for a down payment on a house, a new car, or just want a safety net for unexpected expenses, a savings account is a great option.
Should I prioritize savings or retirement?
The best approach is to balance both options. “You should prioritize an emergency fund before you start investing,” Stanley says. “First step, save one month's expenses in an emergency fund. Second step, pay off high-interest debt—mostly credit cards. Third, start to invest within your 401(k).”
Does a 401(k) count as an emergency fund?
No, a 401(k) should not be considered an emergency fund. While a 401(k) is an excellent tool for long-term retirement savings, it’s not designed for immediate access. If you need to withdraw money from your 401(k) before the age of 59½, you'll face a withdrawal penalty and taxes, which will significantly reduce the funds available to you in an emergency.
An emergency fund, on the other hand, is meant to be easily accessible without penalties or tax implications. It's recommended to keep this fund in a savings account or another liquid, low-risk account where you can access the money quickly when unexpected expenses arise.
It’s important to have a separate emergency fund to cover unexpected costs without jeopardizing your retirement savings.