IRAs vs. 401(k)

You'll Thank Me Later

How much should I save for retirement?

As much as you can.

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

Check out our calculator:
How much will you have at retirement?

What’s The Difference?

The main difference between the two is that an IRA is set up by the individual and funded with their own money, while a 401(k) is set up by an employer and usually includes contributions made by the employer as well.

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

IRA

An IRA is an Individual Retirement Account (also referred to as Individual Retirement Advantage).

Who sets it up: An IRA is an investment account set up by an individual.

Who can contribute: All you need to open an IRA is taxable, earned income.

Benefits

  • Contributions are tax deductible.
  • Contributions can grow tax deferred and withdrawals can be taken later in life to reduce tax liability.
  • Everyone is eligible to enroll (although not everyone can is eligible to receive a tax deduction).
  • Funds are protected from creditors in bankruptcy.
  • Can pass along to heirs.

Types of IRAs

  • Traditional IRA: you invest your money before taxes and then pay taxes on the money when you pull it out of the account.
  • Roth IRA is the opposite. Here, you pay taxes on the money first, and then all earnings grow tax-free. This means you don’t pay any taxes upon withdrawal at retirement.
  • Perks: Income from interest, dividends, and capital gains can grow each year with NO tax penalties.

401(k)

A 401(k) is a retirement savings plan sponsored by an employer. It lets employees save and invest a portion of their paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account.

What the name means: The name 401(k) refers to the section of the U.S. tax code that allows for this tax-deferred retirement planning.

Who sets it up: A 401(k) is an account provided by your employer that you contribute to from each paycheck before income tax. These funds are placed in a special account in your name.

Benefits

  • You do not have to pay taxes on the money you have put into your 401(k) account until you retire.
  • The IRS taxes all withdrawals at your ordinary income tax rate.

Restrictions

  • Because it is employer sponsored, there are certain disadvantages to pulling out the money early.
  • If you make withdrawals before age 59 ½, you usually have to pay a 10% early withdrawal penalty on top of any taxes due.

Who can contribute: Anyone whose employer offers a 401(k) program.

Types of 401(k)s

  • Roth 401(k)s: Newer options from corporate employers that offer tax-free earnings.
  • 403(b)s: For employees of public education entities and nonprofit organizations.
  • 457s: For state and municipal employees as well as employees of qualified nonprofits.
  • Thrift Savings Plans (TSPs): For federal employees.
  • Perks: Some employers have programs where they match your contribution (free money!).

Saving for retirement can be likened to emptying your pockets of spare change everyday.

Obviously this amount will grow as a function of time. At year 2050, you will have a pretty full collecting jar. With a 401(k), your employer provides this jar and sometimes even matches the amount you put in. With an individual account, this is a jar that you get yourself and contribute to.

The Bottom Line

Whether you qualify for an IRA or a 401(k), the key is to start contributing as SOON as possible. And, if you’re more than 10 years away from retirement, you may want to start contributing as MUCH as possible. These are two of the best ways to save for retirement.

Good to know

The money in your retirement accounts is protected from creditors if you are forced to file bankruptcy.

When you leave your employer, you have a few options:

  • Keep your money in your employer’s 401(k) plan
  • Cash it out (with penalties if you are under 59-1/2 years old)
  • Roll it over into another 401(k) retirement plan

 

Works Cited

Dzombak, Dan “IRA vs 401k: Which Is Better for You?” The Motley Fool Web 22 Oct. 2014. Hamm, Trent

“Roth IRA vs 401k? You May Not Have to Choose” The Simple Dollar Web 1 May. 2015. CNN Money

“Ultimate Guide to Retirement” http://money.cnn.com/retirement/guide/?iid=EL

https://investor.vanguard.com/ira/iras

https://www.fidelity.com/viewpoints/retirement/nine-reasons-roth

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