What’s the difference between a 401(k) and an IRA? This is one of the questions that you are bound to ask yourself when you start thinking about your retirement years. Saving for your retirement years is without a doubt one of the best financial strategies, albeit being one that exposes an investor to several risks. Those who take on the challenge to save for the future end up doing so in a 401(k) or an IRA. Today’s article is all about helping you understand the difference between these two articles, and what you can expect when investing through either of them.
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What is a 401(k)?
A 401(k) is essentially a tax-deferred retirement savings account that is offered by employers to their employees. The employees are then expected to contribute funds to this account through an elective salary deferral. This means that a certain percentage of their salary is usually withheld and directed to their 401(k) account.
The money is then deposited in several investments, which are often a collection of mutual funds, that are selected by the sponsor of the account. The funds are selected in such a way that they meet specific risk tolerance, to see to it that the employees on face risk levels that they can stomach. The investments income usually accrues and compounds risk-free.
In recent times, there have been some employers who have started offering Roth 401(k)s. Unlike traditional 401(k)s, the Roth 401(k)s are usually funded with after-tax money, hence are not tax-deductible. The qualified withdrawals are, however, tax-free.
The contributions that employees make to their 401(k) accounts are all pre-tax, meaning that the total contributions that one makes annually usually reduce their total taxable by the contribution amount. For instance, if you earn $35,000 and contribute $5000 to your 401(k), then your taxable income will be $30,000.
The total amount of money that one can contribute to their 401(k) differs from one year to the next one, based on IRS policies. For 2020 and 2021, 401(k) account holders can contribute a maximum of $19,500 to their traditional or Roth accounts. Those aged 50 and above also have to make an additional $6,500 which is viewed as a catch-up contribution.
Individual Retirement Accounts (IRAs)
IRAs are retirement savings that are established by an individual. They can be held by various financial institutions including:
- Brokerage firms
- Investment firms
An IRA can be as simple as a savings account or a regular certificate of deposit account that an individual can hold at a local bank. IRAs that are held by brokerage and investment companies provide their owners with more investment options than 401(k)s. Some of these IRAs can hold:
- Real Estate
Note that some assets, however valuable, such as art are not permitted for use in IRAs by the IRS. Also, unlike 401(k)s, most IRAs do not permit loans.
Traditional and Roth IRAs
As is the case with 401(k)s, the contributions made to traditional IRAs are in most cases not usually tax-deductible. The earnings and the returns usually grow tax-free, hence one has to remit their taxes on the withdrawals made during their retirement years.
The contributions made to Roth IRAs are usually made using after-tax dollars. The qualified distributions from Roth IRAs are usually tax-free.
What are the IRA contribution limits?
The annual contribution limits for IRAs also differ from year to year, depending on the rules set by the IRS. For 2020 and 2021, the traditional and Roth IRA contribution limits are $6,000. People aged 50 and older are also required to make a $1,000 catch-up contribution.
Is it better to open a 401(k) or an IRA?
The question as to whether you should open a 401(k) or an IRA can best be answered by having an individual specify which features are the most desirable ones to them. Generally, a 401(k) allows individuals to contribute much more money each year, than they can with an IRA. Also, a 401(k) is to a great extent easier to manage for investors who do not want to make the investment decisions, since the investments plan may most likely include mutual funds.
Unfortunately, a 401(k) might have a limited variety of investment choices, depending on the financial provider who is charged with the management of the plan. IRAs, on the other hand, come with many more investment choices, if they are opened with investment firms such as brokers. In addition to that, IRAs allow their owners to hold their money in the IRA savings accounts, which is something that you’re not likely to find with most 401(k)s.
If you want to expand the number of investment opportunities for yourself, you can open a unique IRA known as a Self-Directed IRA. With such an account, you can hold a wider variety of assets, including those that the IRS may not allow in the regular IRAs including:
- Precious metals
- Promissory notes
Is it possible to roll a 401(k) into an IRA without penalty?
Yes. If you have any funds in your 401(k) that you would like to move to your IRA for different reasons such as the opportunity to enjoy a wider variety of investment assets, then this is possible. You will, however, have to stick to the guidelines that are specified by the IRS. If you follow the guidelines, then you can make the contributions without getting penalized. Those who do not follow the set guidelines often huge penalties.
Rolling your 401(k) into an IRA can at times be viewed as being a complex process, but there are service providers who can help simplify the process for you.
Have a look at the recommended companies, below, which can for instance help you roll over your 401(k) into a self-directed IRA that can hold gold and silver, and the others that can hold cryptocurrencies.
That will be only for this article in which we have discussed the difference between a 401(k) and an IRA is. I hope you found it helpful, and that with the information presented here, you will be in a better position to make a more informed decision about which option you will rely on as you plan for your retirement years. Let me know if you have any questions about this topic, and whether you need any help to decide whether a self-directed IRA is the best option for you.
I wish you well,
Eric, Investor and Team Member at Gold Retired!