IRAs vs. 401(k)

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How much should you save for retirement?

As much as you can!

An IRA and a 401(k) are two of the best ways to accomplish this goal. They accumulate your contributed money, defer your tax payments, and build your wealth.

Retirement Savings Plans

Both 401(k) accounts and IRAs are financial accounts specifically designed to help you save for retirement and grow those savings through tax-deferred investments. They are types of “Qualified Retirement Savings Plans,” which just means they are recognized by the IRS for special tax treatment.

To encourage people to save, the IRS allows you to delay or “defer” taxation on any income you contribute to these accounts as well as on the earnings from investments made with those contributions.

The Basics

IRA

What It Stands For: IRA = Individual Retirement Account

Who Sets It Up: You

Who Can Contribute: You

How It’s Funded: You can deposit money into your IRA whenever you like up to the annual limit.

401(k)

What It Stands For: 401(k) = The section of the U.S. tax code that allows for special tax treatment of qualified retirement savings

Who Sets It Up: Your employer

Who Can Contribute: You and your employer

How It’s Funded: You pick a specific amount (dollar amount or a percentage of your salary) to be automatically deducted from your paycheck each month and deposited in your 401(k). If your employer also contributes, they will likely do so on a “matching basis,” meaning that they contribute as much as you do up to a certain limit.

What’s the difference between an IRA and a 401(k)?

As you can see above, one big difference between the two is that an IRA is set up by the individual and funded with that person’s own money, while a 401(k) is set up by an employer and can also include contributions made by the employer.

Although both allow you to grow your savings over time without paying taxes on the earnings until later (or maybe not at all) and offer other types of tax benefits, there are also some important differences.

One account isn’t better than the other. Each has its own requirements and advantages. Here is a rundown of both:

Pros and Cons

IRA

Pros

  • Choose when to contribute, how much, and where to open your account.
  • Don’t have to move your account if you change employers.
  • Get to pick your investments or choose a managed portfolio; it’s up to you.
  • Available to anyone with income.

Cons

  • Lower contributions limit than a 401(k).
  • Can’t accept contributions from employers or others; it’s all on you!
  • Roth IRA accounts not available to high-income earners (see below).
  • Not all contributions are tax-deductible for high-income earners or those who already contribute to a 401(k).

401(k)

Pros

  • Since your employer sets it up, there’s less hassle for you!
  • Higher contribution limits than IRAs means you can save faster.
  • You can retire on your employer’s dime since they can contribute too.
  • Contributions come automatically out of your paycheck, which makes saving effortless.

The benefit of employer contributions should not be ignored. Technically, if you have a very generous employer and earn more than the maximum annual contribution limit, you could maximize your own contribution ($18,500 or $24,500) and then stuff your nest egg with up to $36,500 of your employer’s money (but good luck finding a boss that nice).

Cons

  • If you change employers, you have to move your account, which is called a “rollover.”
  • You may have to wait until you’ve worked for your employer for a certain amount of time before you can open an account.
  • You aren’t automatically entitled to all your employer’s contributions.
    • “Vesting” refers to the degree to which you are entitled to keep your employer’s contributions if you leave your job. You may need to work for your employer for a set number of years before you are “fully vested” in your 401(k). Then you can leave your job and take all your employer’s contributions with you. If you leave early, you may only get to keep some of those dollars.

Roth vs. Traditional

Both IRAs and 401(k) accounts come in two flavors: Roth and traditional. Again, neither is better or worse, but the difference is important.

Traditional

Upside:

  • You pay less in taxes in years you contribute to your account.

Downside:

  • You have to pay taxes on those contributions when you’re older and may have limited income.
  • You pay taxes on earnings from investments.

Who It’s Good For:

  • Those who are in a high tax bracket now but will be in a lower tax bracket when they retire.

Roth

Upside:

  • Tax-free income in retirement.
  • No taxes on investment earnings.
  • More flexible rules about early withdrawals of contributed funds–not earnings–since you’ve already paid taxes on those dollars.

Downside:

  • Full taxation on all income in the year you earn it.
  • Those who earn more than $135,000 (single), $199,000 (married filing jointly) aren’t eligible for
  • Roth IRA accounts.
  • Not all employers offer Roth 401(k) accounts.

Who It’s Good For:

  • Those currently in a lower tax bracket but who will be in a higher bracket later.
  • Those who won’t retire for a long time (tax rates may go up in the future and/or you’ll earn more and be in a higher bracket).

Key takeways

  1. Both IRAs and 401(k) accounts are Qualified Retirement Savings Plans, so they get special tax treatment.
  2. There are annual limits to how much you can contribute, but both types of accounts allow for catch-up contributions for those over 50.
  3. Only 401(k) accounts can accept contributions from your employer and have a higher annual limit.
  4. IRAs have lower annual limits but are more flexible and available to (almost) everyone.
  5. Roth accounts take posttax dollars, but you don’t pay taxes when you use the money after retirement.
  6. Traditional accounts give you a tax break now, but you have to pay taxes when you withdraw money later.

Summary

Both IRAs and 401(k) accounts are among the best ways to plan for your financial future. Both have benefits and drawbacks, so do your research to see which options are available to you and what type of account (Roth or traditional) is best for your situation.

Whether you qualify for an IRA or a 401(k)–or both!–the key is to start contributing as soon as possible. If you’re more than 10 years away from retirement, consider trying to reach those contribution maximums every year. The quicker you build up your balance, the more you will benefit from compounded investment earnings over time.

Fun facts

  • IRAs were created in 1974 by the Employee Retirement Income Security Act. They became popular in the 1980s.
  • Only 33% percent of Americans have an IRA. The average balance a person has in an IRA is over $100,000.
  • While cashing out a retirement account is almost always unnecessary, 34% of Gen Xers and 24% of Baby Boomers have used their retirement savings as a convenient piggy bank–a move that can cost a lot in tax penalties.

 

References

  1. Dzombak, Dan “IRA vs 401k: Which Is Better for You?” The Motley Fool Web 22 Oct. 2014.
  2. Hamm, Trent “Roth IRA vs 401k? You May Not Have to Choose” The Simple Dollar Web 1 May. 2015.
  3. CNN Money “Ultimate Guide to Retirement” http://money.cnn.com/retirement/guide/?iid=EL
  4. https://investor.vanguard.com/ira/iras
  5. https://www.fidelity.com/viewpoints/retirement/nine-reasons-roth
  6. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
  7. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions
  8. https://www.rothira.com/roth-ira-limits
  9. https://www.rothira.com/2017-roth-ira-limits-announced
  10. https://www.shrm.org/resourcesandtools/hr-topics/benefits/pages/2018-irs-401k-contribution-limits.aspx
  11. http://money.cnn.com/2017/10/19/retirement/401k-ira-contribution-limits-2018/index.html
  12. https://www.irs.gov/retirement-plans/401k-plans-deferrals-and-matching-when-compensation-exceeds-the-annual-limit
  13. https://www.rothira.com/roth-ira-taxes-and-tax-issues
  14. https://www.thebalance.com/what-you-need-to-know-about-401-k-early-withdrawals-2894147
  15. https://www.forbes.com/sites/ashleaebeling/2017/10/19/irs-announces-2018-retirement-plan-contribution-limits-for-401ks-and-more/#4b03f21925ac
  16. https://www.irs.gov/retirement-plans/401k-plan-catch-up-contribution-eligibility
  17. https://www.irs.gov/newsroom/irs-announces-2018-pension-plan-limitations-401k-contribution-limit-increases-to-18500-for-2018
  18. https://www.forbes.com/sites/greatspeculations/2017/03/17/__trashed-55/#111bdd5d1b32
  19. https://www.cnbc.com/2017/04/28/smartest-dumbest-things-people-do-with-401k-funds.html
  20. https://www.investopedia.com/articles/retirement/03/021903.asp
  21. https://www.bankrate.com/finance/taxes/roth-ira-rules-what-are-they.aspx
  22. https://www.fool.com/retirement/2017/01/20/8-surprising-ira-facts.aspx
  23. https://money.usnews.com/money/blogs/planning-to-retire/2015/05/29/5-surprising-facts-about-iras
  24. https://www.cnbc.com/2016/08/16/401k-nightmares-what-not-to-do-with-retirement-plan-cash.html

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