Some may feel they are too young to start thinking about retirement accounts and some may feel it is too late to get one going. It is never too late and if you are in the labor force earning income then you are not too young to start planning for your retirement. There are many options when it comes to retirement planning. Making an educated choice when deciding which plan can help you to reach your goals. The 2 most common are the 401k and the IRA.
In this article, we will discuss the benefits of each plan and the tax advantages each provides. We will also delve into the key differences between the two accounts. Having this knowledge will help you make the decision to help ensure that you have enough savings set aside so you can enjoy your golden years.
What is a 401K?
The major difference between the 401k and the IRA is that the 401k is offered by an employer. If your employer is not offering this then the IRA is something that you can set up on your own. If an employer wants to give their employers a tax-advantaged way to save, they can offer defined contribution plans such as a 401k. This is a plan set up through your employer where you can contribute a portion of your salary directly into the 401k.
A lot of employers put restrictions on who they offer this type of benefit to. Some companies also require their employees to work for a certain period, such as several months or even up to a year before gaining eligibility for this type of account. Some employers offer matching contributions where they would match dollar for dollar what you contribute up to a certain limit. The employer will typically contribute between 2% and 10% of the employee’s income.
The IRS sets a limit on the amount that can be contributed every year and receive the tax deferral. In 2021 the limit for elective deferrals is $19,500.
What is an IRA?
If a 401k is not offered through your employer or you are self-employed, you can still choose to save on your own and set up an individual retirement account or IRA. IRAs do not offer the matching option, but they can provide some of the similar tax advantages as a 401k.
An IRA is a tax-deferred savings plan established by an individual.
There are many different types of IRA’s, the most popular types are the traditional IRA and the Roth IRA. With the traditional IRA, the contributions are typically tax-deductible, and just like the 401k the earnings and interest grow tax-free. With the traditional IRA like the 401k, you usually need to be 59 ½ to withdraw funds without the 10% early withdrawal penalty. The Roth IRA contributions are made with after-tax dollars but withdrawals in retirement generally will not be taxed. With the Roth IRA you can take out contributions made into the account after 5 years without penalty, but you will need to wait until 59 ½ to withdraw earnings from the account to avoid penalty.
The annual contribution limits for traditional and Roth IRAs are $6000 for 2021.
The major benefit of the IRA and the 401k is the money contributed can grow tax-free. This means there is no taxes on the earnings contributed or the interest earned while in the plan. The income is not taxed until it is withdrawn. At the time of withdrawal, the income is then taxed based on your then income tax rate.
The benefits of this are you first can gain interest on income over time that would have originally been taxed if not contributed to the 401k or IRA. Also, typically one’s income drastically reduces when one retires. If you do these withdrawals in retirement, the income can be taxed at a much lower tax bracket if this is the case.
With this type of tax benefit obviously, there is a drawback. These plans typically do not allow withdrawals before the age of 59 1/2. If there is an early withdrawal, there can be a 10% tax penalty levied by the Internal Revenue Services. These are called early or premature distributions as seen on the IRS website:
The Differences Between a 401k and an IRA
As you can see there are many differences between the two types of retirement plans. Anyone with earned income can open an IRA but a 401k is only available through an employer. A 401k has a higher contribution limit than the IRA and provides the employer match which the IRA does not.
An IRA though generally has many more investment choices than a 401k. In a 401k the investment choices are more limited because the employer is in control of where the funds are deposited. They usually are in a set mutual fund that is preselected and can also have high investment fees over which you have no control.
With an IRA you have a much broader choice of investments. These can be with individual stocks, bonds, or mutual funds through a bank or brokerage. An IRA also allows you to avoid the 10% early withdrawal penalty for certain expenses like higher education, up to $10,000 to purchase a new home or health insurance if you are unemployed.
A 401k plan can offer an option that an IRA typically cannot. With a 401k an employee can take out a withdrawal due to hardship. If this amount is not repaid, then it is taxable. If the amount is repaid, then it can remain untaxed. In general, you cannot take out a loan from an IRA without triggering penalties and interest.
If these comparisons are weighing on you, one thing to remember is that you can contribute to both. A lot of employers only match up to a certain amount, so some people contribute up to the matching amount and then fund the IRA with any more contributions desired after that. This will allow you to get a 100% return on the money through the match and then you can also get the benefits of the expanded investment choices.
What if I leave my job?
A big question that always comes up is what happens with a 401k if you leave a job. You have many options with a 401k when leaving an employer. Your first option is to leave it where it is. If your account is over $5000 it may make sense to just leave the money where is. If it is below $5000 it would make sense to move the money.
An employer can dump an account below $5000 into a high fee IRA which sometimes can shrink rather than grow. If the amount is below $1000, they can force you to cash out and take the tax penalty.
The next option is traditionally called the rollover. You can either roll over the amount in your 401k to another 401k with your new employer or to an IRA with more investment choices. It is extremely easy once you have a new 401k to roll over the funds from your previous account. You can simply elect to have the administrator of the old account deposit the contents into your new account by filling out some forms. This is called a direct transfer.
You can also have the balance of your old account distributed to you in the form of a check. If you deposit this in the new account within 60 days, you can avoid paying taxes. If you are not moving to a new employer or your new employer does not offer a 401k plan you can roll your old 401k into a traditional IRA, and you also will not have to pay taxes.
Of course, you can also take a cash-out option. You can fully liquidate the 401k and take a lump-sum distribution. The drawback and why most financial advisors recommend against doing this is that the entire amount will be taxed and if you are below the age of 59 ½ there will be an additional 10% penalty for early withdrawal.
So, which is best for you?
In conclusion, each type of retirement plan has its benefits in terms of setting yourself up with comfort as you retire. If you are somebody who does not want to or feel they can manage or make a decision on the investment of the money and your employer offers a matching program, then the 401k may be best for you. If you want more flexibility and options, then an IRA can provide that for you with your investment ability.
When making this type of a decision, it’s recommended to reach out to a financial advisor for more information about the plans themselves or an IRS Enrolled Agent or CPA of the tax law involved. There is no answer to which option is best but one can be best for your particular situation and goals.