401(k) or IRA? Most people get confused by which one to get, and that’s assuming that they have knowledge about how retirement accounts work.
As a basic definition, 401(k)s and IRAs are investment plans aimed at helping people save money for retirement. However, this definition is also where the similarities between the two end.
Let’s take a look at the components of IRAs, then 401(k)s, and how to determine where to invest your retirement funds.
What is an IRA?
An IRA (individual retirement account) is a type of savings account used to accrue funds for retirement.
The money you contribute to an IRA can be used to hold investments, such as mutual funds, stocks, bonds, or a combination of many different types. Yes — you get to choose, which is both empowering and a little overwhelming.
Money can be held as cash in an IRA while you decide what to do with it, but doesn’t actually grow until invested towards something specific.
Two Types of IRA: Roth and Traditional
There are two different types of IRA for your consideration: Roth IRA and the traditional IRA. The difference? Mainly in how and when you get a tax benefit.
A Roth IRA is your best retirement account choice if you expect to be in a higher tax bracket upon retirement, than you are right now.
Though it’s impossible to know for sure what tax bracket you’ll be at decades from now (short of placing your trust in a fortune teller), you might try forecasting based on your career path, a possible inheritance, and other similar factors.
With a Roth IRA, contributions are taxed as they’re added to the account. Another consideration for picking a Roth IRA is that your income does not reach the MAGI (Modified Adjusted Gross Income).
MAGI is defined as a calculation that, “…starts with adjusted gross income and then adds back in a number of items such as IRA deductions, self-employment tax, rental losses, student loan interest and other items.”
The IRS goes on to give specific numbers that define MAGI, such as:
- $194,000 for married filing jointly or qualifying widow(er),
- $132,000 for single, head of household, or married filing separately and you did not live with your spouse at any time during the year, and
- $10,000 for married filing separately and you lived with your spouse at any time during the year.
If you’re on the edge and think your income reaches the MAGI, it’s best to consult with a financial planner to determine if a Roth IRA is best for you, of if you should consider another retirement account.
As a general rule, you can contribute up to $5,500 per year, and it’s a very good idea for you to max that out.
A traditional IRA is your best choice if you are eligible for tax deductions now, if your income is too high for a Roth IRA, or if you expect to be in a lower tax bracket upon retirement. In these specific cases, it is advantageous to open a traditional IRA, because every withdrawal is taxed later — upon retirement.
Due to the fact that traditional IRA contributions use pre-tax dollars, that don’t get taxed until you withdraw at retirement, IRAs offer certain tax and earnings advantages. Using pre-tax dollars means larger initial contributions, which then compound over time.
When you choose a Roth IRA, you pay taxes during every contribution (now), so that when you withdraw in the future, those withdrawals will not get taxed. When you choose a traditional IRA, every contribution is tax-deductible, but you have to pay tax for every withdrawal upon retirement (future).
Still unsure what to do? Wells Fargo provides a helpful visual for determining which type of IRA is best for you.
What is a 401(k)?
A 401(k) is a type of retirement account that is typically company-sponsored. Like with an IRA, a 401(k) allows you to siphon off part of your salary for retirement savings.
Contributions to 401(k)s are tax deductible, meaning that you will get taxed when you eventually withdraw money, as with traditional IRAs. One of the main benefits of contributing to a 401k is that some companies offer to match your contributions, up to a certain percentage.
A 401(k) is not a requirement of employment, but some employers offer 401(k)s to reduce tax deduction on their part, or as a perk for attracting top talent.
One of the main detriments to participating in an employer-sponsored 401(k) plan is that you don’t have much of a say in terms of the actual investments that make up your plan — your employers pull rank.
How Employers Can Match 401(k) Contributions
In a 401(k) plan, there are few different ways that employers might opt to match contributions:
- A dollar for dollar match for an employee’s contribution, up to a certain amount, or
- A certain percentage of what the employee has contributed
For example, say an employee contributes 6% of her $50k gross income ($3k) and the company matches that, up to 3% of her salary. They will contribute $1,500, which means she’ll have a total 401(k) contribution of $4,500 that year.
However, should she decide to contribute more, the company will still only match up to the $1500.
According to Investopedia, companies match an average of 2.7% to the employees 6%.
401(k) Plans Types
Though the specifics of the plan are up to the sponsoring employer, a basic 401(k) structure can take a few different forms:
- Traditional plan: employers can choose whether to match employee contributions, or make a set contribution for all employees. However, for the latter option, the employer decides when the employee is entitled to those funds.
- Safe harbor plan: similar to the traditional plan, but employer contributions cannot be forfeited. Employers still contribute to a 401(k) even if the employee does not.
- Simple (or saving incentive) plan: an option for businesses with less than 100 employees.
The Differences Between 401(k)s and IRAs
The main differences between 401(k)s and IRAs come down to structure, contribution levels, and various penalties.
IRAs have the disadvantage of lower contribution limits. Each year, you can contribute up to $5,500 for an IRA vs up to $18,000 for 401(k) if you are below 50 years of age. If you’re 50 years of age or more, you can contribute slightly more — up to $6,500 for IRAs vs up to $24,000 for 401(k)s.
Remember — the more you save now, the longer time it has to compound and grow so that you have a comfortable nest egg at retirement. Though retirement may seem far off when you’re in your 20s, it’s the best time to start the process, and those who don’t take advantage are full of regret later on.
It’s worth knowing that there is no set percentage based on your income required to contribute to a 401(k), just as long as it doesn’t exceed $18k (if you’re under 50 years of age).
There is a 10% penalty for withdrawing money from 401(k)s before you reach 59½ years old. So for example, if you cash out $50k before this age, you only actually get $35k after the 20% withholding tax & 10% penalty.
Similarly, there is a 10% penalty for taking money from your IRA before reaching 59½ years old.
Exemptions are available, though. Such as when you use IRA funds to pay for health insurance after a job loss; or, when you withdraw funds from a retirement plan and later repay it, such as when you buy a house.
401(k) or IRA: Which One Should You Choose?
Based on your situation, it depends. But Investopedia advises that you get both, and max both out, if at all possible.
How much of an effect taxes will have on your final dollar amounts at retirement will depend on circumstances — including your tax bracket upon retirement (and withdrawal), and the difference between your tax rate now, and in the future.
In both cases, it’s hard to say with certainty what will happen — you have to make an educated guess.
In general, 401(k)s contribution limits are higher. They’re also (often) company sponsored, and if you’re lucky, you can take advantage of free money through employer contributions.
But on the other hand, employers can limit your investment choices depending on the company-sponsored plan. For reference, 401(k)s are usually just invested as mutual funds. IRAs offer much more freedom as to where to invest your money.
Now that you know the basic differences between IRAs and 401(k)s, it is up to you to choose where it makes the most sense to invest.
When in doubt, ask for help from a trusted financial advisor. But if possible, create an investment plan that involves both IRA and 401(k) accounts, and contribute as early (and as much) as you can to set yourself up for success in retirement.