What’s the Difference Between a 401(k) and a Savings Account?
A savings account is an individual account you open at a bank or credit union to keep your money safe and earn a little interest. You can use this savings account for anything, whether a short-term goal like an emergency fund or a vacation, or a long-term goal such as a new car or home renovations.
Deposits and Taxes
When you sign up for a 401(k) with your employer, you’ll choose an amount to contribute to your account every paycheck. Your contributions come out of your paycheck, and you won’t have to pay income taxes on that money until you withdraw it. Some employers match contributions. If your employer offers this benefit, it’s like getting free money added to your account. Your pretax contributions to your 401(k) reduces your taxable income for the year, lowering your overall tax bill. When you take distributions on your 401(k) (typically in retirement), you’ll pay income taxes on whatever you withdraw, but your tax rate should be lower in retirement than it was when you were earning the money you used to contribute. In that way, you come out ahead on taxes. In contrast, when you add money to your savings account, that cash has already been taxed through withholding in your paycheck—or it will be taxed by the time you file your tax return. So, there’s typically no same-year tax advantage to putting money into a savings account. However, you can make deposits whenever you’d like without going through your employer first.
Withdrawals
You usually can’t withdraw money from a 401(k) account until you reach retirement age, which typically is defined as 59½ years old. If you do take money out of your account before then, you may have to pay a 10% penalty and taxes on the withdrawn amount. Some exceptions allow you to avoid the penalty, such as using the money to pay for medical expenses, tuition, funeral expenses, or other qualified hardships. You can withdraw cash from a savings account without paying a penalty. However, some banks may require you to keep a certain amount of money in your account or pay a fee. Banks may also limit how many savings transfers or withdrawals you can make monthly. Always check with your financial institution to see if your savings accounts have any restrictions.
Investment Options
When you sign up to participate in your employer’s 401(k) plan, you can choose different investment options. Typically, most investment options are mutual funds, which are vehicles for assorted stocks, bonds, or other securities. However, some 401(k) plans offer employer stock, annuities, and other alternatives. A savings account is cash based, and you can’t invest in mutual funds. Returns will only be the interest you earn, which will compound and grow. However, you can choose the type of savings account:
Regular savings account Online savings account High-yield savings account Money market account
Each savings account type has pros and cons, so comparing your options is important before deciding where to put your money.
Returns Earned
The returns earned on a 401(k) vary based on market performance and the type of investments you selected. Your account balance will go up and down over time and include interest, dividends, and appreciation. According to the Financial Industry Regulatory Authority, stocks have a 10% per year average annual return, followed by corporate bonds at around 6%. While there’s no guarantee that these historical returns will continue, holding investments over time could decrease risk, along with diversification and other strategies. Savings accounts only offer a bank- or credit-union-set interest rate, which tends to be very low. However, the interest rate won’t fluctuate as much as the stock market can. Some banks offer higher interest rates, so don’t be afraid to shop around for the best savings account interest rates.
Risk
According to a 2021 study, 401(k) and IRA assets are most households’ largest financial assets, putting them at risk from market downturns such as the 35% drop due to economic concerns about the pandemic in 2020. In addition, most households invest in equities in their retirement accounts, which can rapidly lose some or even all value if market conditions turn downward. Insurance from the Federal Deposit Insurance Corporation (FDIC) helps protect up to $250,000 in any savings account against loss if the bank runs into trouble. But money in these accounts carries inflation risk—the risk that returns don’t keep up with the rate of inflation. If your savings account pays 2% in interest, but inflation is at 9%, your money is losing value.
Limits
The IRS determines how much you can contribute to your 401(k) every year. In 2022, that amount is $20,500 ($27,000 for individuals age 50 and older). Your bank may limit how much you can put in your savings account, but in general, you can save as much as you like. But remember that only the first $250,000 is insured against loss by the FDIC, per account.
A Best-of-Both Worlds Option
Both 401(k) and savings accounts help you to work toward savings goals. Work with your employer to set up automatic contributions to your 401(k) account, then add money to your savings account each month. By regularly funding both savings plans, you’ll be ready for anything that comes your way.
The Bottom Line
It’s imperative to save for the future, and whether you choose a 401(k) or savings account—or both—comes down to your unique financial goals. Consider a savings account if you’re looking for immediate, low-risk cash access for an emergency or other short- to medium-term goal. But if you want to save for retirement, have a longer time horizon to deal with market dips, and can afford to wait until later to access your funds, a 401(k) account could be a better choice. Ultimately, the best way to save is to have both types of accounts. This will give you the flexibility to cover unexpected expenses and reach your long-term retirement goals.
