This post will compare a traditional IRA vs. 401 (k) and discuss everything you need to know about them to help you make an informed decision when choosing a retirement savings account.
Saving for retirement is one of the most important financial goals everyone wants to achieve. While Americans have a multitude of options when it comes to saving for retirement, 401(k) and Individual Retirement Account (IRA) are indisputably two of the most popular choices.
Both have valuable tax benefits and allow you to invest in assets such as stocks and mutual funds. As such, it is safe to say that both the IRA and 401(k) are excellent retirement account options. However, when it comes to real savings, you need to make a solid decision and choose a retirement savings account that helps you accomplish your goal.
Typically, you want to evaluate retirement plans based on how much you can contribute each year, how the contributions will be taxed, and when you can withdraw the money tax-free. Depending on your investment strategy, you can use one over the other (or combine both).
What is an IRA?
A traditional IRA, or individual retirement account, is a retirement savings account that allows anyone with earned income to save for retirement on a tax-advantage basis. Since IRAs are not offered through an employer, individuals can open an IRA account with their preferred brokerage, bank, or investment firm.
There are different types of IRAs – Traditional IRAs, Roth IRAs, and SEP IRAs – and all have unique tax benefits.
With an IRA, your money grows tax-free or tax-deferred until you take it out at retirement. The tax advantage allows your money to compound at a considerably higher rate, making it possible to accumulate more over time.
Notably, while you must have earned income to set up and contribute to an IRA, non-working spouses are exempted from this requirement. For instance, non-working partners who file tax returns together with their spouses can contribute to a spousal IRA.
The amount you can contribute to your account immensely depends on your age.
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What is a 401 (k)?
Named after section 401 (k) of the Internal Revenue Code, a 401 (k) is a retirement plan offered through employers. At its core, a 401 (k) is a tax-deferred retirement savings account offered by employers, allowing the workers to save for retirement on a tax-free basis.
To contribute to their 401(k), employees usually set a portion of their paycheck to divert to the retirement plan. Because 401 (k) are tax-deferred, the employer deducts the specified percentage and completes the contribution to the employee’s investment account before income taxes are deducted from the employees’ paycheck.
Relative to IRAs, a 401 (k) gives the account holder a lower degree of investment freedom because the investment choices may be limited to what the provider offers.
It is important to note that you can ONLY open a 401 (k) retirement savings account if your employer offers one. Further, the plan provides a fixed set of investments, often mutual funds.
Also read: How you can do a 401(k) to gold IRA rollover
Key differences between an IRA and the 401(k)
So, what’s the difference between a 401(k) and IRA?With both IRA and 401 (k) plans, you don’t pay taxes on your contributions, which makes excellent options for tax-advantaged retirement savings. However, when it comes to picking the right retirement savings account, you need to have a solid understanding of both plans before you can start investing.
Here is how the two plans differ:
1. Eligibility and getting started
IRA and 401 (k) differ right from who can participate in individual plans.
While anyone with earned income and under age 70 ½ can open and contribute to a traditional IRA, a 401(k) is only available through an employer. For the most part, it means you have to be employed to qualify for either plan.
Because IRAs are open to most people, opening an account tends to be easier. On the other hand, you must work at a company that offers a 401 (k) plan to qualify.
For 401(k)s, your employer may automatically enroll you in the plan, offering you an easy and straightforward way to save for retirement. Comparatively, one can open an IRA whenever they wish as long as they meet the minimal requirements.
2. Contribution limits
401(k)s usually have a higher contribution limit than IRAs, and the maximum contributions increase every few years. The same applies to catch-up contributions.
In 2022, employees who want to max out their 401(k)s can contribute up to $20,500 annually to their accounts. Further, workers over age 50 get a catch-up contribution of $6,500.
On the other hand, the annual contribution limit for a traditional IRA is $6,000, with a $1,000 catch-up contribution allowed for folks over the age of 50 years.
Based on these figures, it is safe to say that 401(k) allows you to save more, making it an ideal option for those looking to save a lot more for retirement.
3. How to contribute
Whether or not contributions to your retirement savings account are tax-deductible depends on the type of your account and other factors.
If you are employed, and your employer offers a 401(k) plan, it is imperative to note that the contributions to a 401(k) are always tax-deductible, no matter your income. In comparison, although traditional IRAs generally offer a tax deduction, they may or not offer tax deductions for contributions. Whether or not your contribution to an IRA will be tax-deductible depends on your income and whether you are covered by a 401(k) plan.
The pretax contributions to 401(k) help reduce taxable incomes. In contrast, with IRAs, a deduction is phased out at higher incomes, particularly if you or your spouse is covered by a 401(k).
Whether the contributions are tax-deductible or not, the investment earnings stay untaxed until withdrawn.
4. Withdrawal rules
The money you contribute to your retirement saving accounts grows tax-deferred until you withdraw it in retirement, defined as 59 ½. When you withdraw in retirement, the amount you withdraw will be taxed at ordinary rates for both IRA and 401(k).
Notably, while, in most cases, you should be able to withdraw from your retirement savings account in retirement, with a 401(k) account, you will need to reach a distribution event to withdraw successfully. Besides reaching retirement age, other common distribution events include no longer working with the employer, becoming disabled, sponsoring the plan, and death.
If you withdraw the money before retirement, depending on from which account you withdraw, you may have to pay a 10% penalty on the amount withdrawn and taxes. For 401(k)s, you will have to pay the penalty and taxes, but with some exceptions. If you leave your job at age 55 or older, you can withdraw the investment earnings penalty-free. The withdrawals will be subject to taxes, however.
Traditional IRAs, on the other hand, help you avoid penalties for certain expenses, including:
- Tertiary education for you or your family
- Health insurance (if you have been unemployed for at least 12 weeks)
- Up to $10,000 for a first home purchase for amounts used within 120 days of the actual withdrawal.
- Medical expenses that are more than 7.5% of adjusted gross income.
- Disability
If you have a 401(k), after reaching age 72, you will be forced to take required minimum distributions (RMDs) each year unless you are still working. The required minimum distribution is the minimum amount that a 401(k) account holder must withdraw each year from their account when in retirement. You will have to pay a 50% tax penalty on the amounts of the RMD that were not withdrawn.
Also read: Traditional IRA Withdrawal Rules
5. Portability
Unlike IRAs, 401(k) are attached to the employer. This means if you stop working with the employer who offered the 401(k) plan, you will have to convert the plan or leave it where it was when you stopped working. As for converting, you can roll over your 401(k) to an IRA or 401(k) if your new employer offers the plan.
Whether IRA or 401(k) is better for you depends on the features you desire or expect from a retirement savings account. Generally, a 401(k) allows you to save more money annually and is more manageable for people who don’t want to make investment decisions. The only big problem with 401(k)s is that the plans usually provide a limited number of investment options, depending on the provider managing the plan.
On the other hand, IRA allows you to save less money but offers more investment options, especially when opened with a broker. Even better, IRA allows you to manage your investment.
Here are the pros and cons of individual retirement savings accounts to consider when deciding.
Pros of IRA
- Deductible contributions
- Averagely lower fees
- Tax-deferred growth since all earnings and returns grow tax-free. However, you will have to pay tax while withdrawing in retirement, but still, mature and qualified distributions are tax-free at the time of withdrawal.
- Bankruptcy protection
- Anyone can open and contribute to an IRA as long as they earn at the end of the month.
- Can hold Precious metals such as gold & silver, etc, and also in other alternative assets such as Bitcoin for example.
- Withdrawals can be made anytime.
- Large investment selections, especially if you are dealing with an online brokerage The range of assets available is wide enough, from stocks, mutual funds, and many more.
- There are no minimum distributions in retirement.
- It is easy to obtain IRAs as long as you’ve earned income in a certain year. It only takes a few minutes online, and you will be done with the entire process.
- Roth IRA is a great option, especially if you want to do estate planning
- Spouses are not expected to contribute too, whether they are earning or not.
- A Roth IRA is more flexible than any other retirement scheme.
- IRA does not impose the 10% early withdrawal fee if you opt to withdraw your contributions sooner.
Cons of IRA
- Deductibility of contributions depends on the income earned
- The contribution limits are very low.
- Do not consider employer matches.
- Tax benefit on contributions is not immediate
- There are no automatic payroll deductions
Pros of 401(k)
- There is an employer match
- The income bracket does not limit eligibility
- The annual contribution limit is relatively high
- The account is highly secured against creditors
- Automatic payroll deductions
- The employer maintains the account
- Funds in 401(k) are less expensive than similar funds purchased elsewhere
- Contributions lower tax income during the year of payment.
- Not offered by all employers
- You may be able to access a loan.
- The plan administrators usually offer investment guidance.
Cons of 401(k)
- You have no control over plan and investment costs
- Required minimum distribution begins at 72 years
- The investment selections are limited
- Cannot hold gold
- Distributions at retirement are usually taxed as ordinary income
- The fees paid are quite higher
- Setting up a Roth version is quite difficult
Factors to consider when choosing a retirement plan
- Inflation rate:A retirement plan is usually a long-term investment, and adverse inflation rate fluctuations may greatly affect it. Always choose a retirement plan that won’t be greatly harmed by inflation in the future.
- Expenses: Go for a plan that is economical in terms of pricing and overall charges to avoid wasting your money. Some retirement plans may charge a lot compared to the services offered.
- Make use of the financial planner advice:Not all retirement plans will assign you an investment planner to guide you through the process; however, some will. Choose a plan that will offer you a guide on making investment decisions. Otherwise, you may end up investing in a void project. Generally, IRAs provide more investment freedom than 401(k).
- Vesting period:You should consider your retirement investment needs and compare them with the available vesting periods allowed by the different retirement schemes.
- Weigh the possible risks and returns: For a retirement plan, always go for investments with lower risks and higher expected returns.
- Weigh the retirement benefits and pension:At retirement, you will need to get enough benefits, pension, and returns from your investment plan. Choose a plan that will yield adequate funds to sustain you and your family after you retire.
Final Thoughts
Both IRA and 401(k) are great retirement accounts to consider. Even so, they differ in a number of ways, and one may be better for you than the other. Hopefully, this post will help you make a sound decision when choosing a retirement savings account.
You made a wise decision to read this post, please continue to ALWAYS do your own research before you invest in ANYTHING.
You are a smart person, so I am absolutely sure that you will choose the method that personally suits you and your situation the best!
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I hope you found this short post on a traditional IRA vs. a 401 (k) to be helpful and that you now have a better overview on the subject. Please share your own opinion and experiences in the comment section below! Also, I will be more than happy to answer any questions about this below aswell!
I wish you success!
Michael, founder of Gold Retired
