Though most people will be able to contribute to both, there can be some unique advantages to using one or the other.
For example: 401(k) plans have higher contribution limits making them more attractive for savers who set aside a higher percentage of their income. But you have to work at a place that offers you a 401(k) in order to participate. If you don’t, an IRA could be better tool for you to use at your disposal.
If you’re an early retirement seeker like myself, both types of plans can also offer some useful tricks that will enable you to get access to your money before the IRS minimum age requirement.
Here are the highlights of a 401(k) vs IRA and why one type may be better suited to your needs.
How They Work / Taxes
One clear benefit to using either a 401(k) or IRA is that they both give you the chance to save money before taxes are taken out. At a tax rate of 25%, that works out to roughly 33% more money saved than if you had tried to save your money post-tax in a regular bank savings account.
The mechanics of both are a little different, but they accomplish the same end goal. With a 401(k), your contributions are taken out of your paycheck pre-tax giving the tax-deduction immediately. With an IRA, you make contributions and then declare them when you file your Federal tax return. Both paths ultimately result in lowering your taxable income at the end of the year.
While the 401(k) has become one of the most popular types of retirement plans available, it is still fundamentally a “work-place” plan. This means your employer has to offer one in order for you to participate. Unfortunately, according to Bloomberg this means that 1 out of 5 workers ends up getting left out in the cold.
By contrast, an IRA is an “individual retirement arrangement”. This means it is a retirement plan that you start and manage yourself. All it takes to get started is going online or making a phone call with any brokerage of your choice.
The main requirement of being able to contribute to an IRA is that you need to have earned some taxable income this year. But there is one small catch: Your contribution may or may not be tax-deductible depending on your income level, filing status, and contributions to other retirement plans. The best way to know for sure is to have a look over the official IRS eligibility requirements.
When it comes to “how much you’re allowed to save”, 401(k)’s are clearly the front-runner. They allow you to save up to $18,500 per year (as of 2018) whereas IRA’s only allow an upper limit of $5,500 per year.
Remember that since you’re saving roughly 25 cents in taxes for every dollar you contribute, that higher limit could mean big savings for you! Consider that hitting the maximum contribution would mean:
- 401(k) = $4,625 in taxes saved
- IRA = $1,375 in taxes saved
If you’re age 50 and over, the same goes for Catch-Up Contributions. 401(k)’s will let you add an extra $6,000 whereas IRA’s only let you contribute another $1,000 on top.
Employer Matching Contributions
Employer matching contributions are another huge advantage of using your 401(k). Most employers who offer them will also offer some sort of match; the most common being 50 cents for every dollar you contribute.
Unfortunately with IRA’s, this would be rare – if ever done at all. Because the IRA is something you manage, employers don’t typically get involved.
Honorable mention for the IRA: If you earn money on the side or are self-employed, than participating in something called a SEP IRA can be a huge benefit to your taxes. I do this every year, and it not only lowers my tax burden, but allows me to stash away another $3,000-$4,000 away for retirement. That’s on top of any other 401(k) or IRA contributions I’ve already made!
IRA’s are great because YOU get to choose who and what you’d like to invest in. That means you could go to a broker that offers mutual funds, ETF’s, stocks, bonds, etc. But it could also mean that you include other alternative assets like real estate or precious metals.
Unfortunately with a 401(k), you’re stuck with whatever funds your employer is offering. Case by case, this could be either really good or bad. I’m very fortunate to work for a company that uses Fidelity for their 401(k) plan, and they offer more funds than I could ever care to choose from. But I’ve also heard horror stories of employers who go through some less creditable brokers and offer some very poor fund choices.
To know if you’re 401(k) fund choices are on par with the rest, look at 1) the performance of the funds and 2) the expenses. There should be at least a few funds that compare in performance to that of a simple stock market index fund (returning roughly 10% per year). The expense ratios should also be less than 1%. Less than 0.5% would be even better.
Advantage: Both (IRA slightly ahead)
If you prefer the setup of a Roth-style retirement savings plan, than you’re usually in luck! Most of the time, both types of accounts are offered.
With a 401(k), this will depend on your employer’s plan. If they haven’t updated your plan to include this option, then unfortunately you are out of luck.
That’s why I give a slight advantage to the IRA. You always have the option of choosing either a traditional style or Roth style right from the opening.
Advantage: IRA (usually).
Again, because your employer dictates which funds you can pick from in the 401(k) plan, you’re somewhat stuck paying whatever the broker charges.
But on top of that, 401(k) funds also usually charge some sort of administrative fee. This is a sort of “overall” fee simply for managing the plan. Depending on how much of this expense your employer absorbs, this fee could impact your net savings rate as well.
By contrast with IRA’s, because you can choose where you start them, this means you have the freedom to select a low cost provider like Vanguard or Fidelity. Funds there can cost as low as $5 for every $10,000 invested. Plus, there are usually not any administrative fees since the tracking is all part of their normal paperwork tracking.
Advantage: Generally the same.
For the most part, the IRS stipulates that you must be age 59-1/2 to start making withdrawals from your retirement accounts. Otherwise, there will be a hefty 10% penalty to pay on top of the taxes you owe.
However, there are a few exceptions to this rule:
Advantage: 401(k). If your employer allows you, you can take a sizeable loan from your 401(k) to help cover emergencies. You’ll have 5 years to pay it back. With IRA’s, the term is much shorter limited to just 60 days.
Early Retirement (Less Than 5 Years):
Advantage: 401(k). If you plan to retire by age 55 or older, 401(k)’s offer you a special exception known as the Age 55 Rule where you can start taking your money out early penalty-free. IRA’s do not offer this.
Early Retirement (5 or More Years):
Advantage: IRA. If you plan to retire much sooner than your peers, than you will need to be very strategic about how you withdraw your money. This will usually involve taking out a 72t or making Backdoor Roth IRA Contributions. Both of these strategies will be much easier to execute if you do them inside your IRA instead of your 401(k).
Conversions / Rollovers
Advantage: Generally the same; IRA’s are easier.
For most financial companies, conversions and rollovers are no problem. Usually going from a 401(k) to an IRA or a traditional to a Roth style account involves nothing more than a phone call or completing an online form.
However, as we’ve mentioned with 401(k)’s, your employer’s plan has to allow these sorts of things in order for them to occur. This will vary case to case.
With IRA’s, the decision is all yours. That makes it much easier to do.
Required Minimum Distributions
The IRS requires you to start making mandatory withdrawals on your tax-deferred accounts starting at age 70-1/2. This will apply to both your traditional 401(k) and IRA.
If you elected either to be Roth-style, then RMD’s are not required (since you’ve technically already paid taxes on this savings).
The IRS allows you to pass on the money from either a 401(k) or IRA to your spouse as if it was their own. If you leave either to someone else, they will be required to start making mandatory withdrawals and pay taxes on it.
Readers – Which do you prefer between a 401(k) vs IRA? What are some of the positives and negatives that you’ve found to using one versus the other?
Featured image courtesy of Flickr