Retirement accounts like company sponsored 401(k)s and Individual Retirement Accounts, or IRAs, have become more crucial now than ever when it comes to meeting your individual retirement needs. While you’ve likely heard about each of these types of retirement accounts, you might need help understanding how they fit into your overall retirement plan.
Big Ideas You’ll Learn:
- The pros and cons of 401(k) and IRAs
- The difference between Roth and Traditional 401(k) and IRAs
- Best practices to follow when determining which retirement account is best for your financial situation
- Rules you need to follow to confirm you are eligible for the benefits of IRA and 401(k)s
What Are My Options?
In general, there are two primary retirement accounts available: 401(k)s and IRAs. While each of these accounts are good options, it’s important to understand the difference between the two.
What Is a 401(k) vs. IRA Account?
A 401(k) is a type of employer-sponsored retirement account, also commonly called a defined contribution plan. Named for the section of the tax code that governs them, 401(k)s arose during the 1980s as a supplement to pensions, and are available to employees at most private sector companies. Workers in the public or nonprofit sector would likely have a similar option, although in that case, they are called a 403(b) or a 457(b). Although the name may be different, the general principles behind these accounts are the same.
With a 401(k), workers save in a company sponsored account and the money is pulled directly from their paycheck each month. In most cases, the employee’s money will be invested in the stock and bond market, usually using mutual funds, ETFs or index funds. However, the funds chosen are specific to the employer, and will vary somewhat.
While you can only invest in a 401(k) if your employer offers a plan, you can open an IRA all on your own. IRAs, or Individual Retirement Accounts, are a powerful retirement investment tool for the average investor. You can invest in an IRA regardless of whether you have a work sponsored 401(k), assuming you have earned income. It will allow you to purchase investments — such as stocks and mutual funds — with significant tax savings that can save you thousands over the life of the account.
What Is a Roth Account vs. Traditional 401(k) / IRA Account?
There is also one further detail that new investors should know — there are two types of each — the traditional 401(k) / IRA and a Roth 401(k) / IRA. All these types of retirement accounts offer tax advantages, if certain rules are followed.
“Traditional” 401(k)s and IRAs provide immediate tax savings by reducing your taxable income when you contribute to these accounts. Your contributions grow tax-free until you start to withdraw the funds. When you withdraw your money, however, the withdrawals are counted as taxable income at your tax rate in effect at the time of withdrawal.
“Roth” 401(k)s and IRAs offer a different tax advantage. You contribute after-tax income to these accounts. In other words, you pay tax on the funds now, and your earnings and withdrawals will be tax-free in the future.
In the chart below, we summarize the strengths and weaknesses of each type of account, with further explanation in the sections that follow.
There’s a lot of nuance across these accounts. Let’s dig into the details to figure out which accounts are the best for your situation.
Pros of a 401(k)
There are many pros to investing in a 401(k), aside from the tax benefits mentioned above. A few of the most important benefits to this type of account are as follows:
Perhaps the greatest benefit of an employer-sponsored retirement plan is that your employer could contribute to your retirement as well through a matching contribution. So, for instance, if you make $50K annually and your employer matches up to 3% of your salary that you contribute to your 401(k), that’s an extra $1,500 a year. It’s essentially free money, although it may sometimes be subject to a vesting schedule tied to the number of years you remain employed with the company. Employer matching is definitely something you should take advantage of if you have access to one of these accounts.
Higher Contribution Limits
In addition to an employer match, 401(k) contribution limits are higher than that of IRAs. In 2019, the IRS raised the 401(k) contribution limit from $18,500 in 2018 to $19,000 in 2019. Additionally, if you’re over the age of 50, you can contribute an additional $6,000 in catch-up contributions per year.
Ability to Borrow
While it’s not something that should be taken lightly, 401(k) plan administrators generally allow you to access your money without any tax penalty if you’re in dire need of cash in the short-term, like in the case of unexpected medical expenses. Most 401(k) plans will allow you to take a hardship withdrawal, or 401(k) loan, of up to $50,000 or 50% of your account balance — whichever is less. However, you must then repay the amount of money you’ve accessed back into your 401(k) within the stated time frame, otherwise you will face taxes and penalties.
Because 401(k) plans fall under the Employment Retirement Income Security Act of 1974 (ERISA), they enjoy a credit-protected status. Unlike funds invested in an IRA, any retirement savings in a 401(k) cannot be seized or garnished by commercial creditors, although this exemption does not extend to unpaid federal taxes.
As with most retirement plans, the IRS imposes a 10% tax penalty on withdrawals taken before a certain age. This is to discourage using these funds for expenses that are not strictly related to retirement, and is essentially a way to protect private investors from themselves.
That said, one of the pros of investing in a 401(k) over other types of retirement savings accounts, such as an IRA, is that they have an earlier withdrawal age. When you reach the age of 55, you can take out penalty-free withdrawals from your 401(k), no questions asked. The IRA, in contrast, requires you to wait until age 59 ½ to withdraw your funds without penalties.
Cons of a 401(k)
While there are many advantages to saving for retirement in a 401(k), it’s important to be aware of the drawbacks before you decide what retirement investment strategy is best for you.
Because 401(k)s are run by Third Party Administrators, many plans suffer from a crucial drawback: high fees. The average fees for a 401(k) — including management fees and expense ratios — hovers around 1.00%, but can be as high as 2.00%. While that might not seem like a lot on paper, those fees can eat away at your principal, and over the course of your investment in the plan, can cost you thousands of dollars.
Fewer Investment Options
Again, as 401(k)s are chosen by your employer, your options are limited when it comes to the investment options available. This means rather than having the option to invest in low cost index funds or ETFs, you may only have the ability to pick from a selection of more high-cost mutual funds. One other area to watch out for is the option to invest in your employer’s stock. While investing in the stock is a show of your dedication to the company, be cautious of the risks of concentrating too much of your retirement investments in your employer’s stock.
Required Minimum Distribution
Required minimum distributions from 401(k)s require the holder to withdraw a certain amount each year beginning the year you turn 70 1/2 or the year you retire. If the required minimum distribution is not met, you may have to pay 50% in excise taxes on the amount that wasn’t withdrawn. Unfortunately, this rule applies to both traditional and Roth 401(k)s, even though taxes were already paid on the Roth. (If you’re planning to leave these accounts to your heirs, you should consider rolling over your Roth 401(k) into a Roth IRA to avoid this rule.)
Some 401(k) plans have a vesting schedule for employer matching funds that is intended to encourage employees to stay with the company. This means that if the employee leaves the company before they are “vested,” they can lose any matching employer contributions and the growth those account contributions have gained over their time with the company — although any employee contributions are theirs to take with them.
Pros of an IRA
As with most decisions in life, there are advantages and disadvantages to choosing one option over another. The same holds true when evaluating IRAs.
Lower Management Fees
The freedom to choose your IRA without any limitations imposed by an employer plan is perhaps one of the greatest benefits when it comes to this type of investment vehicle. As mentioned above, the average fees for a 401(k) — including management fees and expense ratios — is 1.00%, but can be as high as 2.00%. On the other hand, many IRAs have no management fees at all.
More Investment Choice
In addition to the freedom to pick an IRA with lower fees — or none at all — there is also more diversity when it comes to what type of investment you’d like to make. With IRAs, you are often offered many choices in stock and bonds, as well as exchange traded funds which typically have significantly lower expense ratios than mutual funds.
Consolidate Investments: The “Rollover IRA”
As previously mentioned, when you leave a company, you can choose to “roll over” the money in your previous employer’s 401(k) into an IRA — and you can do so with 401(k)s from multiple employers. This means you can continue to let your retirement savings grow in a single tax-deferred traditional IRA, reducing the amount of time and effort required to manage your investments.
There are some tricks to this to ensure you aren’t hit with penalties and taxes upon conversion. The easiest way to complete the “rollover” is to transfer like-to-like, meaning Traditional 401(k) to Traditional IRA, or Roth 401(k) to Roth IRA. Do you research to ensure you’re protected.
First-Time Home Buyer Withdrawals
Unlike your 401(k) investment, you can withdraw up to $10,000 penalty free from your IRA during your lifetime to pay for a first-time home purchase. Usually, if you were to take an early withdrawal from your IRA before the age of 59 1/2 you would pay a 10% tax penalty. However, while there’s no penalty, you would still have to pay federal income tax on the funds withdrawn.
Cons of an IRA
As you’ve seen, there are many benefits to an IRA retirement savings account. However, there are also a few drawbacks.
Lower Contribution Limits
The chief disadvantage of an IRA is the lower contribution limits. While a 401(k) allows you to contribute up to $19K in the 2019 tax year, IRAs have a contribution limit of $6,000 in 2019, up from $5,500 in 2018.
The catch-up contribution is also considerably less than what is allowed for a 401(k), as those over the age of 50 can only make additional retirement savings contributions above the minimum of $1,000 for a maximum annual contribution of only $7,000.
Weaker Creditor Protection
Also, while 401(k)s are protected from commercial creditors, money saved in an IRA does not enjoy the same level of security. If you work in a profession with higher risk of litigation, or if you run a business and seek to secure your savings from creditors, you may choose to keep your funds in your 401(k). IRA funds only have creditor protection in the case of bankruptcy under federal law, while inherited IRAs don’t receive this protection at all. That said, the level of creditor protection varies from state to state.
As a busy person, you might find automated payroll deductions to be the easiest way to contribute to your retirement. This convenience is a clear advantage of your employer’s 401(k). To replicate these deductions with an IRA, ask your IRA provider to set-up automated transfers from your checking or savings account to your retirement account.
So Which is Best, IRA or 401(k)? Traditional or Roth?
1. Don’t Leave Money on the Table
If you have access to a 401(k) with a company match, always invest as much as needed in your employer plan in order to capture the full company contribution.
2. Pay Attention to Fees
Employer 401(k) plans will generally have higher fees than an IRA. As such, once you’ve contributed enough to your 401(k) to capture your employer match, start contributing to an IRA if you quality (see below to see if you do). Then, aim to max out your IRA contribution. Once you’ve reached the limit, you should then make the maximum contribution possible to your 401(k). After that, if you still have money available to invest, you should consider saving in a brokerage account.
3. Optimize Your Tax Strategy
While steps one and two are general rules of thumb, if you’re going to optimize your returns in retirement, you’ll need to have a tax strategy. This is where you’ll want to determine whether a Traditional IRA vs. Roth IRA (or Traditional 401(k) vs. Roth 401(k)) is best for you.
As mentioned above, you can choose to contribute your regular income either before tax (traditional), or after tax (Roth). With a traditional IRA or 401(k), your money grows tax-deferred until retirement, when you pay taxes on the funds upon withdrawal. In contrast, with a 401(k) or Roth IRA contribution, you pay taxes when you invest, allowing your money to grow tax-free until retirement when you can withdraw without paying taxes.
So, Between a Traditional vs. Roth Retirement Account, Which One is Better?
When deciding which type of IRA is best for you, you should consider your current tax bracket versus your future tax bracket.
If you’re currently in a lower tax bracket, make more income than allowable for a traditional IRA, or believe tax rates will go up in the future, a Roth 401(k) or Roth IRA might be best. If you believe you have high income potential in your retirement, the tax-free withdrawals offered by Roth options become more attractive. You’ll pay taxes for your current tax bracket, and no matter if tax rates go up in the future or not, you still won’t have to pay tax when you make your withdrawals in retirement.
On the other hand, if currently you file your taxes in a higher tax bracket and expect it to be lower when you retire, diverting some of your earned income into a traditional retirement account could reduce your taxable income. As a result, you could lower your current tax payment and receive a less onerous tax bill — or even better, get a tax refund.
4. Know If You Want to Retire Early
Another consideration when deciding what account is best for you is whether you think you’ll retire early and need access to the money before you hit retirement age. Although financial experts would strongly discourage early withdrawals from any retirement account, a Roth IRA (as opposed to any 401(k) or a traditional IRA) lets you take out your contributions — the money you put into the account but none of its earnings — at any time without the need to pay income taxes or an early withdrawal penalty.
5. Automate Your Contributions
Whether you choose an IRA or a 401(k), aim for the convenience of automated contributions to your accounts. For IRAs, automate transfers from your checking or savings account into your IRA. Your bank or IRA provider should be able to assist you with this. For 401(k)s, contributions through payroll deductions are the easiest way to “set it and forget it”.
6. Review Your Plan Regularly
Knowing the best retirement plan or plans for you, starting your retirement savings plan and automating your savings put you on a great path. Now, schedule a review of your plan on – you could start with an annual or semi-annual review. See if your investments are properly allocated according to your retirement goals.
If you’ve changed jobs, you can roll over the 401(k)s from your former employer into your new employer’s plan, or move the money into an IRA. Keep track of your 401(k)s from previous employers, and consolidate your retirement savings so that your investments are easier to manage in an IRA with lower expense ratios.
Check in with a financial planner, or with the firm that handles your retirement account. They should be able to give you guidance regarding your plan and investments and how these match your needs.
Make Sure You Qualify for the Tax-Advantaged Benefits
Now that you’ve got your retirement strategy, you need to make sure you qualify for your chosen retirement plans. we’ve dug deep into the pros and cons of 401(k)s and IRAs, there are a few key questions that typically arise when determining which one is appropriate for your situation.
Do I Qualify for a 401(k) or Traditional IRA?
For 401(k)s, this is easy. If your company offers a 401(k), you generally qualify (though there may be some restrictions if you an executive or owner of the company).
Assuming you have earned income during a given year, most taxpayers will also be eligible for a traditional IRA. However, your participation in an employment retirement plan and your tax filing status have an impact on the amount of money you are eligible to deduct for contributions to a Traditional IRA.
Are Contributions to My Traditional IRA Tax Deductible?
If neither you nor your spouse is an active participant in your company’s retirement plan, then you can deduct your Traditional IRA contributions regardless of how high your income is.
However, if you are considered an active participant in your employer’s retirement plans, your IRA contribution may or may not be tax deductible. As a single taxpayer, you will get a full deduction for your IRA contribution when your adjusted gross income is below $64K, a partial deduction between $64K and $74K, and no deduction if you make above $74K.
Married couples face different requirements. For instance, income taxpayers who are married filing jointly will get a partial tax deduction when their adjusted gross income is between $103K and $123K, but no deduction if they make more than $123K. And finally, married taxpayers who file separately will get a partial tax deduction when their adjusted gross income is less than $10K and no deduction above $10K.
An Example May Help:
Kristin works and is also contributing to her employer’s retirement plan. If Kristin is single with an adjusted gross income of $61K, she could get a full deduction for eligible contributions to her traditional IRA. However, if she earns $75K, she’s out of luck. And if she’s married and filing taxes with her spouse, she will also be unable to claim a deduction if she makes $75K her husband makes $50K, as together their income will be $125K — exceeding the $123K cutoff to qualify for the tax deduction.
If your income is below these thresholds and you want an additional tax deduction for the year, then contributing to a traditional IRA in addition to your workplace retirement plan is a great option.
Do I Qualify for a Roth IRA?
In contrast to Traditional IRAs, Roth IRAs have income limitations that determine whether you can contribute, not just whether you can deduct the investment on your taxes. For the 2019 tax year, you can only contribute to a Roth IRA as a single tax filer if you earn $137K or less annually, with a reduced contribution limit if you make more than $122K. For married couples, the combined income limitation is $203K annually or less, with a reduced contribution limit if you make more than $193K.
Retire With Confidence
Gone are the days of working your entire career for one company with the guarantee of a monthly pension when you decide to hang up your hat. But while the average American can’t rely on a steady employer pension anymore, that doesn’t mean enjoying a comfortable retirement is out of the question.
Although retirement planning has become more and more the individual’s responsibility, the 401(k) and IRA are powerful tools available to help you achieve your goals and save for retirement. And while you seek clarity when trying to decide the best retirement strategy, as long as you start saving now, you’re on the right track.