Which is better between an IRA and a 401(k)? Do the two retirement investment vehicles have similar benefits or are they significantly distinct? What should you know about either account before opening one? Today’s post will take you through this IRA vs 401(k) debate so that you can gain enough information to help you decide which one you will be opening. Stick on till the end to find out more.
401(k)s and Individual Retirement Accounts (IRA)s are very useful when one is saving for their retirement years. If you are getting started with saving for your future, but you are not very certain about the options to choose, it can be quite useful to know the pros and cons of each type of account. Doing this helps you know what you are getting yourself into so that you do not end up losing your hard-earned money.
Let’s start by seeing how each type of account works.
How does a 401(k) work?
You are only capable of accessing a 401(k) if it is offered by an employer. In some companies, you’ll also be required to work for a given period, say months or years, before becoming eligible to open a 401(k).
A 401(k), which is also referred to as a defined contribution plan, allows employees to make contributions (usually a percentage of their salary), to their company’s retirement plan. 401(k) contributions happen through payroll deductions, in that a certain amount of money has to be taken from your paycheck, and channeled to your account.
There are also some companies that offer to make contributions for or on behalf of their eligible employees. A common type of this type of employer contribution is the 401(k) match, in which the amount contributed depends on the employers’ policies. The matching contribution is in most cases anything between 2% and 10% of an employee’s income and is in most cases usually contingent upon the level of participation of the employee.
IRS requirements & rules
Every year, the IRS announces the limits on the amount of money you can contribute to your 401(k). Those who are younger than 50, can deposit not more than $19,500 in their 401(k) account. Employees aged 50 or above can place an extra $6500 in their 401(k), which leads to a total contribution of $26,000. There are also some limits for the high-income employees, which are also set by the IRS.
Those who contribute to 401(k) accounts have to wait until 59 ½ to start withdrawing the funds in their account, to avoid penalties. The standard penalty for those who withdraw their money before 59 ½ years is 10% of the money that they withdraw. They also have to pay taxes on their withdrawal. There are, however, some exceptions to the early-withdrawal penalty, such as when you decide to leave your job when you are 55 years or older- you can, in this case, decide to take penalty-free withdrawals from your 401(k).
Upon hitting 72 years, you are required to start taking required minimum distributions. You can, however, delay the RMDs if you are still working. Some employers offer their employees traditional 401(k)s and Roth options. With traditional 401(k)s, employees do not pay taxes on the amount they deposit into their accounts, but their withdrawals are considered taxable income. People, on the other hand, deposit after-tax dollars into their Roth accounts, so that they do not have to pay taxes on the distributions they take during retirement.
How does an IRA work?
For you to create and contribute to an IRA, you must have an earned income. There are, however, some exceptions to this rule. Those who are married and file their tax returns jointly can make contributions to their spousal IRAs for their nonworking spouse. There are also income limits placed on those who want to open IRAs. For instance, if your modified gross income goes over $140,000 for a single person or $208,000 for those who file jointly, then they cannot open a Roth IRA.
Those who have an IRA but have not turned 50 are allowed to deposit $6000 into their accounts. If you are 50 or older, then the IRS rules state that you can only contribute $7000 to your IRA.
With an IRA, you can decide how you will invest your funds. Most IRAs allow people to invest in paper assets such as bonds, ETFs, and stocks. You can also have a financial advisor help you sort out your options and fees.
Two types of IRAs
There are two types of IRAs – traditional and Roth IRAs. Traditional IRA account holders do not pay taxes on the funds that they contribute to their account, but the distributions they take during their retirement years are taxed. One must be at least 59 ½ years to start withdrawing their funds with no penalties. Withdrawing funds before this age attract a 10% penalty on the total amount withdrawn, along with taxes on the withdrawals.
Saving for your retirement using a Roth IRA allows you to make after-tax contributions to your account. The withdrawals are generally not subject to taxes. Roth IRA account holders can withdraw their contributions to the account at any time. They cannot, however, withdraw the earnings from their investments if their account is not at least 5 years old.
Unlike traditional IRAs, Roth IRAs do not mandate people to start taking distributions at a certain age.
The main differences between 401(k)s and IRAs
Despite there being some similar features between Roth IRAs and traditional IRAs, these two types of accounts have their unique features as well. The main differences between the two accounts are:
- Anyone who has an earned income is eligible to open an IRA, but one can only open a 401(k) through or under their employer.
- IRAs generally have more investment choices than 401(k)s
- A 401(k) is better for those who want higher contribution limits.
- You can get an employer match with a 401(k), but not an IRA
I believe that the perception of which of the two accounts is better differs significantly based on the above-listed differences. You are best-placed to decide on the elements of either account that you cannot do without, based on your personal financial needs and objectives. You can also take a look at what self-directed IRAs have to offer, just to establish whether you have better chances of making more retirement investment income by opening one. Check out our reviews of the top-recommended self-directed IRA service providers:
That will be all for this article in which we have looked at “which is better between an IRA and a 401(k)?” My hope is that you found the article informative, and that you’re now in a position to decide on which of the two accounts is worth using as you save for your retirement years. Let me know what your thoughts are about the types of retirement savings accounts, in the comments section.
I wish you well,
Eric, Investor and Team Member at Gold Retired!