While Social Security is a valuable resource when it comes to pensions, for those who can afford to stash away money, the wise thing to do is participate in a retirement plan. A 401(k) and an individual retirement account (IRA) are both great ways to save for retirement as they allow you to invest in your future in a tax-efficient manner. If you are lucky, you won’t have to choose between one or the other as you are allowed to participate in more than one retirement plan. But bear in mind that each plan comes with its own unique advantages and disadvantages.
The key difference between a 401(k) and an IRA is that 401(k)s are employer-sponsored accounts, so you can only join if you work for a company that offers them. Moreover, it is your company that decides what investments to offer, so you have little control over what investments you can make and how much you pay in related costs. Due to it being a benefit, your employer may limit which employees may join it. Contributions are usually made through deductions from your paycheck. Don’t worry if a 401(k) isn’t available at your workplace as there are other employer-sponsored retirement accounts you might be eligible for. These include the 403(b) and a 457(b). Even without any of these employer-sponsored plans, you still have options to build your retirement savings.
In contrast, traditional and Roth IRAs are set up by individual taxpayers, which means that you can open them yourself at a bank or a broker. Anyone with an earned income can set up an IRA and you as an individual will be responsible for establishing the plan and contributing to it.
Should you participate in a 401(k) or an IRA?
If you can, it’s best to join both. Should you be forced to choose between the two for whatever reason, it’s a wise move to max out your 401(k) plan, otherwise you risk leaving free dollars on the table. Many employers match a portion of employee contributions to a 401(k), often up to 6 percent of your total salary. If you are eligible, you can set up a part of your paycheck to be automatically contributed to your 401(k).
Provided your income and saving habits allow it, you should also set up an IRA to take advantage of the tax allowances offered by these accounts.
401(k) and IRA contributions
The Internal Revenue Service (IRS) sets an annual cap on both 401(k) and IRA contributions. In 2021, employees can contribute up to $19,500 to a 401(k). If you are 50 or older, the taxman will allow an additional $6,500 contribution to a 401(k). It’s super important to check whether your employer offers a 401(k) with a company match. If that is the case, your best bet is putting enough money in your 401(k) to get the maximum match as it guarantees a 100% return on your money. Some employers will only match half of the funds you contribute but that’s still a pretty sweet deal.
If you have an IRA account, you can contribute a maximum of $6,000 per year and $7,000 if you are 50 or older. Some of the contributions may be tax-deductible, depending on your income and marital status. Note that Roth IRAs come with an income limit.
| 401(k) | IRA |
|---|---|
| Employer-sponsored account | Individual account |
| No income limit | Income limits may apply |
| Contribution limit: $19,500/year ($26,000/year if you are 50 or older) | Contribution limit: $6,000/year ($7,000/year if you are 50 or older) |
| Investment options may be limited by the plan | Wide range of investment options |
| Penalties may apply if you withdraw your funds before the retirement age | You may be able to withdraw your contributions before the retirement age |
Investment options
When it comes to 401(k)s, investment options are limited to what your employer has chosen, which in most cases includes mutual funds. When you are trying to achieve a specific portfolio balance, these limitations can become a problem.
With an IRA, you have much more freedom to choose your investments and align them with your retirement goals. IRA holders can invest in stocks, bonds, mutual funds and even more exotic assets.
Withdrawal rules
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Seeing how both types of accounts are meant for retirement, the IRS limits your options of withdrawing money before you reach the official retirement age. Early withdrawals typically carry a penalty. If you withdraw cash from a 401(k) or IRA before you turn 591/2, you will owe a 10 percent penalty to the IRS on top of ordinary income taxes.
Rules governing IRA withdrawals are a bit more flexible and there are a range of exemptions from the early withdrawal penalty, including medical emergencies, higher education expenses and the purchase of your first home. With a 401(k), you must prove severe financial hardship to obtain an exemption from the early withdrawal penalty.
Employees at some companies can take out 401(k) loans, meaning they can borrow money from themselves. Individuals are allowed to borrow the lesser of $50,000 or 50% of the total amount of the 401(k). A 401(k) loan may seem like a great idea, but it can easily lead to trouble. If you lose your job, you must repay the entire loan or pay income taxes and the 10 percent penalty if you are under the age of 59½.
Bottomline
Both types of retirement accounts offer great tax benefits and you can contribute to both at the same time. The main difference between the two is that 401(k)s are offered by some employers while IRAs are set up by individual taxpayers. While the contribution limit for 401(k)s is higher than for IRAs, the latter offers a wider array of investment options.
