This is week three of our series covering retirement and taxes. So far, it’s all been about Roth and traditional IRAs, but this week will be a bit different.

We’ll look at the 401(k), another fundamental retirement vehicle that can help keep Uncle Sam out of your pockets.

What is a 401(k), and why should you care?

A 401(k) is a retirement savings plan that lets employees set aside part of their salary before taxes are taken out. Like Roth and traditional IRAs, the 401(k) is another way to save for retirement while saving on taxes.

Like all IRAs, that money goes into investments inside your 401(k) and (hopefully) grows as you work toward retirement. And like a traditional IRA, you can make withdrawals that are taxed at your post-retirement tax rate.

So, in those ways, the 401(k) and the IRA are related. But there are differences, both good and bad.

Let’s start with the good.

Advantages of a 401(k) over an IRA

One of the most significant advantages of a 401(k) is if your employer offers a match. Let’s say you set aside 3% of your paycheck to put in a 401(k), and that percentage equals $100. Your employer might reward your efforts by putting in an extra 3%. So instead of having just $100 to invest every paycheck, you have $200. No such thing exists in an IRA. Not every 401(k) has that advantage. It’s up to the employer to offer it. But they all have the advantage of higher contribution limits.

Uncle Sam calls the shots regarding how much you can put in a tax-advantaged retirement plan. But he calls them much looser with a 401(k) than an IRA. IRA contribution limits in 2023 are capped at $6,500 until you are age 50. Then you can bump it up to $7,500. That’s okay, but your contribution limit before age 50 on a 401(k) in 2023 is $22,500, more than three times the IRA amount. After age 50, you can sock away up to $30,000 per year.

Like any investment plan, there are potential downsides you should be aware of.

Potential Pitfalls of 401(k)s

The advantages of 401(k)s are real, but so are the disadvantages. They are subtle but dangerous.

The first issue is that some 401(k) options are limited. Unlike an IRA that can potentially open up huge swaths of the stock and bond market, some 401(k)s restrict you to a handful of funds.

That leads to the next issue. Some of those funds have very high fees that can eat into gains. So, while a fund might tout 10% annual return rates in the prospectus, fees lower your actual returns.

Finally, the temptation is to take out a loan against your 401(k). Employers’ rules on this are different, but there is often no penalty like with a traditional IRA.

So, the temptation to put a dent in your earning power might be greater with a 401(k).

The Bottom Line

You may be able to contribute to both an IRA and a 401(k) if your employer does not have any rules against it. But if you can’t, a 401(k) is a great place to start saving for retirement and reducing your tax burden.