401k or IRA? Let's look at each investment option and understand the similarities and differences so you can make the best retirement decisions for you.
When you're planning for retirement (or even just thinking about getting started with your retirement plan), do you choose a 401k plan or an individual retirement account (IRA)? These plans may be similar but choosing one or the other could affect how you save for your retirement. Each may have tax implications, employer involvement, or investment options regarding your money. How do you decide which is best for you?
Each retirement account has unique benefits and impacts that you have to choose between. Your choice may not be 401k vs IRA. You may find there are advantages to having both. The real advantage is educating yourself on how they will allow you to invest now and retire in the future.
Ultimately, your retirement plan needs to build towards your retirement saving goals, so let's look at each investment option and understand the similarities and differences so you can make the best retirement decisions for you. It's a good idea to be as informed as possible when making decisions that could affect your future, so here's a breakdown and some helpful hints.
What is a 401k?
A 401(k) is an employer-sponsored retirement plan that allows you to contribute directly from your earnings before taxes are deducted from your income. (Those parentheses around the 'k' come from the actual tax code for which the account is named, in case you were curious.)
For the purposes of simple math, if you earn $2,000 per paycheck and you decide to contribute 5% of your earnings to your 401k, your employer would deposit $100 from your paycheck directly into the retirement account your employer created for you. If that amount were deposited after your income tax is deducted from your earnings, the 5% employee contribution would be closer to $73.
Who manages your 401k
Much like your employer-provided health insurance plan, you may not have a choice over what company manages your company's retirement account. You do have choices about how much you contribute and how those dollars are invested within your account. You have additional options, too. Stay tuned.
Employer contributions to your 401k
In addition to the pre-tax benefit, one of the most common perks of a traditional 401k is that employers may offer a matching contribution up to a certain percentage. For example, if your employer offers to match your contributions up to 6%, it's in your best interest to also contribute at least 6% so that you get all that money your employer is offering towards your retirement. Otherwise, you're saying "no" to extra savings in your retirement account.
401k employee contribution limits
The Internal Revenue Service does limit your 401k contribution in a single calendar year, but the amount may change from year to year. Limits are published by the IRS on its website.
What is an IRA?
An IRA, or individual retirement account, is all about the individual — no employer involvement. Anyone can contribute to their own IRA until they reach the age of 70½ years of age.
Similarities to a 401k account
An IRA account and a 401k account do have similar features. The funds you deposit into your IRA account can be tax-free. If you've already paid income tax on your earnings and then deposit the money into your IRA, the IRA contribution can be included when you file your taxes. This will allow those contributions to be deducted from your taxable income. It is important to know that the IRS does set limitations on tax-free IRA contributions based on individual income limits, including specific limits for those who file joint tax returns.
Like a 401k account, IRAs have maximum contributions allowed each calendar year regardless of income. These amounts differ from 401k contribution limits. The IRS posts these IRA contribution amounts on its website, too.
Differences from a 401k account
One of the biggest distinctions between a 401k and an IRA is that there is no employer contribution. IRAs may be ideal if an employer does not offer a 401k retirement account to its employees or if you are self-employed.
An individual retirement account may also be beneficial if you want to contribute more to your retirement than is allowed in your 401k. You might also open an IRA if you want to roll over your funds from an existing 401k, or a 401k from a previous employer. As the IRA owner, you choose what company manages your retirement savings account.
IRAs for individuals and small-business owners
A SEP IRA (simplified employee pension individual retirement arrangement) also offers the ability for a self-employed or freelance employee to contribute money on behalf of their self-run business to the individual as an employee of the business.
A Simple IRA might also be suitable for small business owners rather than a 401k. Employees are required to contribute to Simple IRAs on behalf of their employees.
Roth IRA tax differences
A traditional 401k or an IRA contribution offers the tax advantage of making contributions tax-free. When you retire, you will pay taxes when you make a withdrawal from these accounts.
With a Roth IRA, you pay taxes on your contribution prior to adding it to your retirement account. Upon retirement, those distributions from the Roth IRA do not require tax payments. This may be beneficial if you are in a lower tax bracket when you contribute to the account than you may be at retirement.
Roth IRAs also include a specific income limit based on both you and your spouse's earnings. This may impact your decision to choose a Roth IRA, but if you are just starting out in your career, your tax bracket may be much different in several decades, so the choice now may be worthy of consideration.
Like other IRAs and 401k accounts, there is a contribution limit set by the IRS for Roth IRAs based on your income and your tax filing status.
Can you have both?
The main difference between the two types of accounts is that employers offer 401ks, while IRA accounts are opened by individuals. Since your employee contribution to either is entirely voluntary, you may choose either or both retirement accounts.
Having both a 401k and an IRA provides the greatest opportunity to make the investment choice that best suits you. If you have questions about which option is best for you, speak to a financial advisor.
If you are offered a 401k that includes employer contributions, this is often the place to start contributing enough to receive the maximum match from your company. If you're eligible, you can also open an IRA and contribute the annual maximum.
If you have a 401k from a previous employer, you can roll it over into your new 401k with your current employer or into an IRA. Just like that, you could have both types of retirement accounts.
How to choose between a 401k vs IRA
Oh, choices. Why do they have to be so hard to make? Well, this one doesn't have to be. There are a few key things to consider when comparing an IRA and a 401k: contribution, cost, and flexibility.
A 401k has a significantly higher maximum contribution level than an IRA. Plus, having an employer contribution towards your retirement is money that you should not pass up. You may hear employer contributions described as "free money," but keep in mind this is one of your employee benefits and if it is offered, it is part of your overall earning package. Take advantage of it.
While you can choose if you want your investments to go towards a specific stock, bond, or mutual fund with either type of retirement account, only an IRA allows you to choose your investment company, too. This may make it easier to manage all your retirement accounts if you have more than just your employer-offered 401k.
When choosing between a 401k and an IRA (or even both), you might want to consider whether it is more advantageous to contribute taxes now or when you begin your required minimum distribution upon retirement. This may not be immediately obvious, and the advice of a financial advisor may help guide your decision.
You might also consider how employment changes affect your decision. Say you leave your job and you're no longer eligible to contribute to that employer's 401k, then you need to seriously consider the carrying cost associated with either option. The cost of a 401k can vary greatly (ranging from 0.5% to 2%) and typically an IRA is less expensive.
The decision to invest in a 401k vs an IRA is different for everybody, and really it depends on your individual set of circumstances. What your decision boils down to is whether your employer matches contributions:
If your employer offers a 401k with a company match: You can put money in your 401k to get the maximum match. That match may offer a 100% return on your money, depending on the 401k.
If your employer doesn't offer a company match: You might want to skip the 401k and start with an IRA. With an IRA, you'll have access to a large selection of investments, and you'll avoid the fees associated with some 401ks. After contributing up to the IRA limit, you always have the option to pay into a 401k for the pre-tax benefit it so graciously offers.
When it comes to retirement, there's no such thing as saving too much. It's in your best interest to use all the savings and investment tools available to you. Start early and begin building your retirement even if you have yet to decide when you want to retire, or what your retirement plans may be.