When it comes to saving for retirement, you’ve got choices. This is good news since financial circ*mstances and preferred investment strategies are personal to each of us.
But the flipside is that all these choices can leave you a bit confused. And if you start to feel a little overwhelmed by all the different features of each type of account, it’s easy to get stuck and not choose anything. Maybe you feel intimidated by all the investing mumbo jumbo, or you’re afraid you’ll make the wrong decision.
First of all, there is no “wrong” decision. Yes, there might be good, better and best, and you’ll learn to distinguish the difference for your own personal situation as you continue to educate yourself.
But don’t let your lack of knowledge keep you from saving in a retirement account. *Any* savings vehicle you pick will be better than sinking that money into stuff that only depreciates or keeping it under your mattress.
Two of the major types of investment accounts you can choose from are the 401(k) and the IRA. Both are great to grow your retirement savings, but there are some differences between them.
You might discover that only one will work for you, or that using both is the best decision. In this post, I’ll go over how both are similar, how they differ, and how to decide between them.
Table of Contents
What is a 401(k)?
A 401(k) is a tax-advantaged retirement account offered by many employers that their employees can contribute to. To take advantage of this type of account, you must work for an employer that offers this particular plan.
About 40 years ago, American workers would stay with one employer for decades and then depend on pension and social security to support them through their retirement years. In 1980, for instance, 38 percent of American employees were covered by pensions. Fast-forward to 2017, and only 15 percent of American workers have a pension (according to the Bureau of Labor Statistics).
Pensions have been replaced largely by 401(k) plans, which were introduced in 1980 as a result of provisions to the tax code. This provision, called Section 401(k), allowed employees to avoid being taxed on deferred income. The 401(k) plan was then subsequently created as a more tax-friendly retirement program. Within two years of its inception, nearly half of all major companies were offering 401(k)s or looking into it.
Here are some features:
- Only available through an employer that offers the plan
- Contributions from all employees are held in one single plan determined by the employer, and each individual’s account balance is tracked separately
- Contributions are made pre-tax
- Money is typically invested in mutual funds, which are pre-selected by the employer
- You can generally make withdrawals without penalty at the normal tax rate once you reach 59-1/2
- Required minimum distributions begin at 72, unless you are still employed
- Distributions are started only after certain circ*mstances are met (e.g., you’ve retired, died, become disabled, reached 59-1/2)
- There is a Roth version for after-tax contributions
The benefits of the traditional 401(k)
There are several benefits to the Traditional 401(k) retirement plan. Consider these features when you’re choosing a retirement investment account:
- Many employers offer to match contributions, up to a percentage of your salary (typically 3%)
- Contributions are made with pre-tax dollars and can therefore reduce your tax liability
- Earnings and returns grow tax-free
- The annual contribution limit is generous, at $19,500 per year. There is also an additional $6,500 catch-up contribution option for people 50 and over.
- You can take out loans or hardship withdrawals from your 401(k)
- Your eligibility is not limited by income
- Funds in a 401(k) may be less expensive than identical funds purchased outside of a 401(k)
The drawbacks of the traditional 401(k)
Even though the 401(k) is a great way to grow your retirement savings, there are some drawbacks to the plan.
- Your investment options are limited to the plan chosen by your employer
- You have no control over the plan or the investment costs
- You may have to meet a vesting requirement for employer matching contributions
- Unless there’s an exception, early withdrawals and earnings are taxed and subject to a 10% penalty
- Usually have to pay higher fees
Many financial advisors recommend the IRA over the 401(k) because of the difference in investment choices. Let’s go over the features, benefits and drawbacks of the Traditional IRA.
What is an IRA?
An individual retirement account (IRA) is also a tax-advantaged investing tool, but it’s set up by a financial institution (instead of an employer) to help individuals save for retirement.
The implementation of the IRA was a result of the Employee Retirement Income Security Act, passed by Congress in 1974. The plan was created for those employees who were not offered a pension, but also to provide a way to maintain a tax-deferred status for any qualified assets when an employee was terminated.
Some of the features of an IRA include:
- They are held by banks or brokerages (not through an employer)
- Include several different assets, such as stocks, bonds, CDs, and real estate
- You can generally make withdrawals without penalty at the normal tax rate once you reach 59-1/2
- Required minimum distributions begin at 72
- There are several types of IRAs to choose from
- Contributions are made pre-tax
- Annual contribution limit is $6,000, and a $1,000 catch-up option for account owners 50 and over
The benefits of the traditional IRA
Here are a few benefits that the IRA provides:
- Unlike the 401(k), the account holder is allowed to own many different assets within the account and you typically have a large investment selection
- Investment options include any investment available through your account provider
- Earnings and returns grow tax-free
- You can generally deduct some or all of your contributions, lowering your tax bill
- You won’t be taxed until the funds are distributed
- You can open separately from an employer
- The fees are generally lower than 401(k) plans
- If you are under 59-1/2, you may withdraw money without penalty for 60 days (after that you will be taxed and penalized)
The drawbacks of the traditional IRA
Here are the drawbacks:
- Contribution limits are much lower than the 401(k)
- Tax deductions for contributions are phased out at higher incomes, or if you and/or your spouse are enrolled in a workplace retirement account
- Unless there’s an exception, early withdrawals and earnings are taxed and subject to a 10% penalty
- Required minimum distributions begin at 72, regardless of your employment status
- There is no long-term loan option
- There are no employer contribution matches
Which plan is better?
Regardless of which one you choose, you’ll experience these same features from either plan:
- tax advantages to the investor
- contributions reduce taxable income in the year they’re made
- contributions are made pre-tax
- investment earnings are not taxed until withdrawn
- distributions in retirement are taxed as ordinary income
- required minimum distributions generally begin at age 72
- taxable withdrawals are subject to a 10% early distribution tax if under age 59-1/2 at the time of withdrawal
- offer “catch-up” contribution option for those 50 and over
- protected from general creditors to whom you owe outstanding debts
- both come in a Roth version for after-tax contributions
- both plans subject to investment, administrative and service fees
According to many financial advisors, a good determining factor to help you choose between the two plans is the employer’s matching option for the 401(k). If your employer offers a 401(k) plan, along with a percentage match, this should take priority over any other plan. If they don’t, then the IRA may be your best option.
If you have a matching option
If your employer will match a percentage, this is free money you should definitely take advantage of. Think of it as a 100% guaranteed return on the percentage matched, in addition to the extra interest that free money will generate!
So, first and foremost,contribute enough to the 401(k) to receive the full match.
Once you’ve completed this step, you can either contribute more to your 401(k), or you could invest the remainder of your funds in an IRA.
As stated above, the IRA gives you many more investment options, along with lower fees, than a 401(k). Because you have more control over the funds you invest in, many people think the IRA is the superior choice.
However, the maximum contribution limits are much lower for the IRA. So, if you contribute as much as allowed into an IRA and still have retirement savings to invest, you can then put those remaining funds into your 401(k).
The important thing is to take full advantage of the matching contribution – then you can decide between the two, depending on your priorities.
If you don’t have a matching option
Although many employers offer a 401(k) plan with a matching option, there are still millions of workers that do not have access to this benefit.
If your employer doesn’t offer a 401(k) plan at all, then the IRA is a great option for your retirement savings. You’ll experience great tax advantages, as well as all of the other benefits listed above.
If your employer does offer a 401(k), but without a matching option, you may still want to go with the IRA. The greater investment options and lower fees make this plan a better choice in many circ*mstances.
But with the lower contribution limit, you’ll max out the IRA very quickly. When you do, you can then invest the remainder of your retirement savings into your company’s 401(k).
The bottom line
Both IRA and 401(k) plans allow employees to save money from their paychecks to invest for retirement and thus earn tax-deferred interest along the way. You have the option of contributing to either or both, just keep in mind that traditional 401(k)s are sponsored by employers, and IRAs are individually filed. The main difference between the two is how much you can contribute and how taxes are treated.
If you feel stuck in your decision (for whatever reason), go with the path of least resistance. This will probably be your employer’s 401(k). All you need to do is sign up for automatic payroll deductions through your human resources department. They’ll set up your account, and your contributions will be made automatically every pay period.
The bottom line ispick a plan and start saving! The sooner you start investing money for retirement, the more your money will grow before you retire.
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