IRA vs 401(k) – What’s the Difference Between 401(k) and IRA?

ira vs 401k

IRA vs 401(k): What’s the Difference Between 401(k) and IRA?

Individual Retirement Accounts (IRAs) and 401(k) plans are the two most common vehicles used to save for retirement. Is there any difference between an IRA vs 401(k)?  Both offer tax benefits and have flexible contribution options. Both can provide retirement savings benefits to employees as well as business owners, even self-employed. Many people choose to save in just one type of account, but you don’t have to pick one, you can use both.   IRAs and 401(k)s both offer tax benefits to retirement savers. It’s fine to contribute to both. Otherwise, first get any 401(k) match you can, then max out your IRA or Roth IRA. This can help maximize your returns and minimize your costs. The difference between IRA vs 401(k) is outlind in more detail below.

IRA vs 401(k)

A 401(k) is an employer-sponsored retirement plan. This means you must have a job with a company that offers this benefit in order to participate.  Also, your company’s not required to offer it.  Some companies do, and some don’t. If your company offers a 401(k), you can contribute part of your paycheck and your money gets invested.  When it comes time to  retire, you keep whatever returns your contributions have earned you.  Additionally, there are some options for tax breaks along the way.

An individual retirement account (IRA) is a retirement account you set up for yourself. You don’t have to work for a company that has one, you do this for yourself, regardless where you are employed.  With an IRA, you put in money, and when you retire, you get to keep whatever returns you’ve earned.  IRAs also come with some nice tax breaks too.

Besides the employer aspect, another main difference between a 401(k) and an IRA is the contribution limit. With a couple of exceptions, you can contribute more to a 401(k). The limit for 2020 is $19,500, and up to $26,000 if you’re 50 or older. The limit for most IRAs is $6,000, and up to $7,000 if you’re 50 or older. e

IRA vs 401(K) – Defined Contribution Plan

Most retirement plans are defined contribution plans.  This means you contribute a certain amount each month, quarter or year.  The payout you receive during retirement is based on the market value of the account.  IRAs and 401(k)s are most commonly defined contribution plans.  Also, they both offer tax-advantaged retirement savings. However, there are a few key differences between these types of plans. The good news is that you don’t have to choose one over the other. If your finances allow, you can — and should, if possible — contribute to both a 401(k) and an IRA.

What is a 401(k) Plan?

A 401(k) plan is a tax-advantaged, defined-contribution retirement account.  These plans are offered by many employers to their employees. It is named after a section of the U.S. Internal Revenue Code. Workers can make contributions to their 401(k) accounts through automatic payroll withholding.  Also, their employers can match some or all of those contributions. The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money, hopefully during retirement.

A 401(k), as well as a 403(b) and 457, are qualified employer-sponsored retirement plans. If your employer does not offer a 401(k) or other sponsored plan, you should probably just begin saving in a Roth IRA or traditional IRA. But if you have access to an employer plan — especially if the employer offers matching contributions — that’s the best place to start.

Many employers offer a matching contribution up to a certain percentage of your salary. For instance, if your employer will match your 401(k) contributions up to 6% of your salary, you should always contribute at least 6%. If not, you’re turning down free money.  The money you contribute to your 401(k) account is pretax money, meaning you will not be taxed on that money during the year you earned it. You will pay taxes on it when you withdraw it during retirement. During 2020, employees are allowed to contribute up to $19,500 of pretax income to a 401(k), and those over age 50 can contribute an additional catch-up contribution of $6,500. (Source: hermoney.com)

WHAT’S AN IRA?

An individual retirement account (IRA) allows you to save money for retirement in a tax-advantaged way.  An IRA is an personal retirement account set up at a financial institution.  It allows an individual to save for retirement with tax-free growth or on a tax-deferred basis. The 4 main types of IRAs each have different advantages:

  • Traditional IRA – You make contributions with money you may be able to deduct on your tax return.  Any earnings can potentially grow tax-deferred until you withdraw them in retirement.  Many retirees find themselves in a lower tax bracket than they were in pre-retirement.  So, the tax-deferral means the money may be taxed at a lower rate.
  • Roth IRA – You make contributions with money you’ve already paid taxes on (after-tax).  Your money may potentially grow tax-free, with tax-free withdrawals in retirement.  Of course, certain conditions must be met.
  • (SEP) IRA Is a simplified employee pension.  A (SEP) IRA is a retirement savings plan established by employers for the benefit of their employees and themselves. Self-employed individuals can set an account up as well.  Employers may make tax-deductible contributions on behalf of eligible employees to their SEP IRAs.  It is their choice.
  • SIMPLE IRA – A (Savings Incentive Match PLan for Employees) IRA allows employees and employers to contribute to traditional IRAs set up for employees. It is ideally suited as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan.

Traditional IRA

The opportunity to contribute to a 401(k) is limited to people employed by companies that offer such plans.  However, anyone can contribute to a traditional IRA (individual retirement account).  Like a 401(k), a traditional IRA offers tax-deferred growth on your investments.  This means the assets in the IRA will not be taxed until they are withdrawn. A traditional IRA may also offer tax-deductible contributions for people who don’t participate in an employer-sponsored plan.

Roth IRA

A Roth IRA offers opposite tax advantages from a traditional IRA.  You pay tax on income before you make contributions to the Roth IRA.  But, you’ll pay no tax on withdrawals of either your earnings or contributions when you make withdrawals in retirement. However, not everyone qualifies for a Roth IRA. To qualify in 2020, you’ll have to have an adjusted gross income that is less than $124,000, or $196,000 for married couples filing jointly.  The limit for annual contributions to an IRA is $6,000 for 2020, and $7,000 for people over 50. That limit is the same for both traditional and Roth IRAs. You have until the day your taxes are due (July 15 for the 2019 tax year) to set up and fund your Roth and/or traditional IRA for the previous year. (Source: hermoney.com)

IRA vs 401(k) Eligibility Requirements 

To be able to set up and contribute to an IRA, you must have earned income. However, there are some exceptions. For instance, if you are married and file your tax return jointly.  In this case, you can contribute to a spousal IRA for a nonworking spouse.  However, you’ll only be able to access a 401(k) if it is available through your employer.  A 401(k) plan is a company-sponsored retirement account.  Employees can contribute directly from their paycheck. Some companies also require their employees to work for a certain time before becoming eligible.  Usually, this period is six months to a year, before being able to contribute to a 401(k) plan.

Who Can Contribute to an IRA vs 401(k)?

With a 401(k), contributions are usually made through payroll deductions. This means you can have an amount taken out of each paycheck and set aside in the account. In addition, some companies offer to contribute to 401(k) plans on behalf of eligible employees. One common type of employer contribution is a 401(k) matching scheme. The amount the company can match depends on the company’s policy. A matching contribution will typically be between 2% and 10% of the employee’s income.  It will usually be contingent upon a certain level of participation by the employee.  You can make IRA contributions by setting aside a certain amount each year.  However, it is very common to have payroll deductions made automatically into the account on a regular basis.

IRA vs 401(k)  Contribution Limits 

If have an IRA and have not yet turned 50, the IRS allows you to place up to $6,000 in the account in 2020. If you are 50 or older, the IRA contribution limit is $7,000.  There are much higher limits on how much you can contribute to a 401(k) each year. In 2020, if you are younger than 50, you can put up to $19,500 in a 401(k) account. If you are older than 50, you can place an additional $6,500 in the account, for a total 401(k) contribution of $26,000.

IRA vs 401(k) Withdrawal Criteria 

Traditional IRA and 401(k) account owners both typically need to wait until age 59 1/2 to withdraw funds to avoid penalties. If you take out money before age 59 1/2, you could be charged a 10% penalty on the amount withdrawn and also have to pay taxes on the withdrawal.

However, 401(k)s and IRAs both have some exceptions to the early withdrawal penalty. For example, the Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, allows retirement account holders impacted by the coronavirus pandemic in 2020 to take out up to $100,000 with no penalties. If the amount is paid back to the account within three years, no taxes are due. Those with 401(k) accounts who leave their jobs at age 55 or older can take penalty-free 401(k), but not IRA, withdrawals. IRA holders can take penalty-free withdrawals for a variety of specific circumstances, including health insurance after a layoff and college costs.

Traditional 401(k)s and IRAs both generally require distributions after age 72.  However, a 401(k) plan may allow you to delay required distributions if you are still working. There are also separate guidelines for account holders during the coronavirus outbreak.  Required distribution has been waived just for the year 2020 as part of the CARES Act.

If you save for retirement in an after-tax Roth IRA, there are fewer withdrawal restrictions. You can take out contributions made to the account at any time, provided the account is at least five years old. You’ll need to wait until age 59 1/2 to withdraw earnings accumulated in the account if you want to avoid penalties. Roth IRAs do not require you to start taking distributions at a certain age.

Tax Advantages of an IRA vs 401(k)

Both 401(k)s and IRAs offer a traditional and Roth option. With a traditional 401(k) or IRA, taxes are not paid on the amount deposited into the account.  Also, withdrawals are considered taxable income. You deposit after-tax dollars in a Roth account,  you generally won’t need to pay taxes on the distributions.

Saving in a 401(k) and an IRA 

You might be able to contribute to both a 401(k) and IRA as part of your retirement preparation. It is a great way to prepare for retirement – if your finances allow.  One way to do this is to contribute the maximum amount you can to a 401(k) each year. After you reach that limint, you can place additional funds in an IRA.  Obviously, this will increase the amount of tax-free money you’re saving for retirement each year. However, those who earn more than certain IRS limits may be prohibited from saving in both types of accounts in the same year. (Source: money.usnews.com)

IRA vs 401(k): How to Decide

Both 401(k)s and IRAs offer valuable tax benefits to people who are saving for retirement.  Just remember, you can contribute to both at the same time. The main difference between the two types of accounts is that employers offer 401(k)s, while IRA accounts are opened by individuals.  Anyone can just go to a broker or a bank to open an IRA. However, with an IRA, you have access to many more investments. With a 401(k), the maximum annual contribution limits are more than three times greater than an IRA. If you’re trying to choose whether to start with an IRA or a 401(k), here’s a quick solution:

  • If your employer offers a 401(k) with a company matching contribution – Put enough money in your 401(k) to get the maximum matching contributio. That matching contribution will likely offer a 100% return on your money, depending on the 401(k). For example, some employers promise a 100% match up to 3% of salary. That means, if your salary is $50,000, your employer will put in $1,500, as long as you also contribute at least $1,500. Once you reach the maximum matching threshold, go max out an IRA for the rest of the year.  Once you max out your IRA, return to the 401(k) and resume contributions there.
  • If your employer doesn’t offer a company matching contribution Skip the 401(k) at first and start with an IRA or Roth IRA. You’ll get access to a large selection of investments when you open your IRA at a broker.  You’ll also avoid the administrative fees that some 401(k)s charge. After contributing up to the IRA limit, fund your 401(k) for the pre-tax benefit it offers. (Source: nerdwallet.com)

IRA vs 401(k): The Details 

If you have the means to max out both a 401(k) and a traditional IRA or Roth IRA, you should be commended. If not, this IRA vs 401(k) road map will help you prioritize where your retirement dollars should go.  Your first step depends on whether your employer matches your contributions to your workplace savings account.

If your employer offers a 401(k) match 

Step 1 – Contribute enough to earn the full match.

Check your employee benefits handbook. If you see that your employer matches any portion of the money you contribute to the company 401(k) plan, do not bypass this opportunity to collect your free money.

A company matching program is one of the biggest benefits of a 401(k). It means that your employer contributes money to your account based on the amount of money you save, up to a limit. A common arrangement is for an employer to match a portion of the amount you save up to the first 6% of your earnings.

Even if a 401(k) has limited investment choices or higher-than-average fees, carve out enough money from your paycheck to get the full company match, as it’s effectively a guaranteed return on those dollars. Also note that employer contributions don’t count toward the 401(k) annual contribution limit.

Step 2 – Contribute as much as you’re allowed to an IRA.

Depending on which type of IRA you choose — Roth or traditional — you can get your tax break now or down the road when you start withdrawing funds for retirement.

  • A traditional IRA is ideal for those who favor an immediate tax break. Contributions may be deductible — that means your taxable income for the year will be reduced by the amount of your contribution. But, if you’re also covered by a 401(k), your deduction may be reduced or eliminated based on income. If you (or your spouse) has a workplace retirement plan, check out the IRA limits.

  • A Roth IRA is a good choice if you’re not eligible to deduct traditional IRA contributions, or if you don’t mind giving up the IRA’s immediate tax deduction in exchange for tax-free growth on your investments and tax-free withdrawals in retirement. Roth IRA eligibility is not affected by participation in a 401(k), but there are income limits. You can see the latest Roth rules on our IRA limits page.

Step 3 – After maxing out a traditional IRA or Roth IRA, contribute to your 401(k).

Even after you’ve gotten the employer match — and even if your investment choices are limited, which is one of the main drawbacks of workplace retirement plans — a 401(k) is still beneficial because of the tax deduction.

The money you contribute to a 401(k) will lower your taxable income for the year dollar for dollar. And don’t forget about the added benefit of tax-deferred growth on investment gains. (Source: nerdwallet.com)

If your employer doesn’t offer a 401(k) match 

Step 1 – Contribute to a traditional or Roth IRA first.

Not all companies match their employees’ retirement account contributions. When that’s the case, choosing an IRA — and contributing up to the max — is generally a better first option.

Why start with an IRA? One of the biggest benefits of an IRA is that it offers access to a virtually unlimited number and type of investments, giving you much more control over your investment options: You can bargain-shop for low-cost index mutual funds and ETFs instead of being restricted to the offerings in a workplace retirement account, and you can avoid paying the administrative fees that many 401(k) plans charge.

Step 2 – After maxing out IRA benefits, then contribute to your 401(k).

Here again, the tax deferral benefit of a company-sponsored plan is a good reason to direct dollars into a 401(k) after you’ve funded a traditional or Roth IRA.

Only in the worst cases — a retirement account with truly crummy, high-fee investment choices and high administrative costs — would it be advisable to completely avoid your company plan.

Remember that if your income passes certain thresholds and you or your spouse put money into a workplace plan, your ability to deduct traditional IRA contributions may be reduced or eliminated. If you aren’t eligible for a traditional IRA deduction, you may still be eligible for a Roth IRA. Also, even if you’re not eligible to deduct your traditional IRA contribution, you can make nondeductible contributions and still benefit from tax-deferred investment growth. And it’s possible to convert an IRA to a Roth IRA by using a so-called backdoor Roth IRA. (Source: nerdwallet.com)

401k to IRA Rollover

When you leave a job, you pack up your family photos and other personal items and move on to your next opportunity. But what do you do with your 401(k) plan? Most people roll the money over to an IRA.  This is because they gain access to more investment options and have more control over the account. Some brokerage firms even offer cash incentives.  For example, some brokers offer bonuses ranging from $100 to $2,500 when you roll over your 401(k) to one of its IRAs, depending on the amount. Plus, moving your money to an IRA could help you streamline your investments.

But a rollover isn’t always the right move.  Sometimes it’s best to simply leave the money where it is. With millions of dollars to invest, large 401(k) plans have access to institutional-class funds.  These funds can charge lower fees than their retail counterparts. That means you could end up paying less to remain invested in the 401(k). There are other perils to a rollover.  If you’re not careful, you could end up with a portfolio of high-cost investments with subpar returns.  This issue is in the spotlight as a result of the debate surrounding the proposed fiduciary rule.

What about cashing out the account when you leave your job and taking a lump sum? Unless your financial situation is dire, that’s never a good idea. You’ll owe taxes on the entire amount, plus a 10% early-withdrawal penalty if you’re younger than 55.  (Source: kiplinger.com)

Reasons to roll over a 401(k) to IRA

Rolling over the money from your 401(k) to an IRA is still the best move in many cases.

Your plan has high-cost investments. 

Many large 401(k) plans offer low-cost options that have been carefully reviewed by the plan’s administrators.  But, there are other 401(k)s that are dragged down by underperforming funds and high costs. Even low-cost plans may charge former employees higher administrative fees if they choose to keep their 401(k).  Some plans offered by small and midsize companies are loaded with insurance products that charge unnecessarily high fees.

Companies are required by law to disclose the fees they take out of your account to pay for administrative costs. You should always review your quarterlyand yearly statements for details. Companies are also required to provide an annual summary of the plan’s investment costs.  These costs should be expressed as a percentage of assets, or an expense ratio. You can use this information to see how your retirement plan’s mutual fund expenses compare with the expense ratios of similar funds. Average expense ratios for retirement plans have declined, partly because plans feature more index mutual funds. The average fee is 0.68% for stock funds and 0.54% for bond funds, according to a 2015 survey by the Investment Company Institute.

You have a trail of 401(k) accounts. 

If you chang jobs frequently, you could accumulate a number of overlapping funds.  These may not suit your age and tolerance for risk at this point in your life.  Younger baby boomers switch jobs an average of 12 times during their careers, according to the Bureau of Labor Statistics.  If that is the case, it can make sense to consolidate all of your old 401(k) plans into a single IRA. Another option is to roll 401(k) accounts from former employers into your current employer’s plan, assuming that’s permitted.

You want more fixed income options.

Most 401(k) plans have a solid lineup of stock funds.  But, they’re often much weaker when it comes to fixed-income options. In many cases, choices are limited.  Also, plan trustees are often focused on encouraging participants to accumulate as much as they can.  This typically results in accumulating stocks and stock related funds. However, as you get closer to retirement, you’ll probably want to shift to a less-aggressive mix of investments. Rolling your money into an IRA will provide you with a wide assortment of fixed-income options, from international bond funds to certificates of deposit.

You want flexibility for withdrawals. 

According to the trade group – Plan Sponsor Council of America, about two-thirds of large 401(k) plans allow retired plan participants to take withdrawals in regularly scheduled installments – usually, monthly or quarterly.  Roughly the same percentage allow retirees to take withdrawals whenever they want. But other plans still have an all or nothing restriction.  You either leave your money in the plan or withdraw the entire amount. In that case, rolling your money into an IRA will enable you to manage your withdrawals and taxes you’ll pay on them.

Even if your 401(k) plan allows regular withdrawals, an IRA could offer more flexibility. Many 401(k) plan administrators don’t let you specify which investments to sell.  Instead, they take an equal amount out of each of your investments. With an IRA, you can direct the provider to take the entire amount out of a specific fund and leave the rest of your money to continue to grow.  (Source: Kiplinger.com)

Stick with the 401k If…

In addition to lower costs, many 401(k) plans offer stable-value funds.  This is a low-risk option you can’t get outside of an employer-sponsored plan. With recent yields averaging about 1.8%, stable-value funds provide an attractive alternative to money market funds. And unlike bond funds, they won’t get hammered if interest rates rise. There are other good reasons to leave your money behind:

You plan to retire early…or late. 

In general, you must pay a 10% early-withdrawal penalty if you take money out of your IRA or 401(k) before you’re 59½. There is, however, an important exception for 401(k) plans.  Workers who leave their jobs in the calendar year they turn 55 or later can take penalty-free withdrawals from that employer’s 401(k) plan. But if you roll that money into an IRA, you’ll have to wait until you’re 59½ to avoid the penalty – unless you qualify for one of a handful of exceptions. Keep in mind that you’ll still have to pay taxes on the withdrawals.

Another wrinkle in the law applies to people who continue to work past age 70, which is increasingly common. Ordinarily, you must take required minimum distributions from your IRAs and 401(k) plans starting in the year you turn 70½. These distributions are based on the value of your accounts at the previous year’s end and on a life-expectancy factor found in IRS tables. But if you’re still working at age 70½, you don’t have to take RMDs from your current employer’s 401(k) plan. And if your plan allows you to roll over money from a former employer’s plan into your 401(k), you can also protect those assets from RMDs until you stop working.

You want to invest in a Roth IRA but earn too much to contribute. 

Another strategy is to move money to a Roth IRS.  However, rolling over your former employer’s 401(k) to an IRA could make it more expensive to do that.  You must pay taxes on your contributions to a Roth IRA, but withdrawals will be tax-free when you retire. But there are income restrictions that if you exceed, you can’t contribute directly to a Roth. There’s no income limit, though, on Roth conversions.  This has given rise to the backdoor Roth IRA. High earners can make after-tax contributions to a nondeductible IRA, and then convert the money to a Roth. Because the contributions to the nondeductible IRA are after tax, there is usually no tax on the conversion.

“Unless, that is, you already have money in a deductible IRA.  And you certainly will, if you roll over your former employer’s 401(k) into an IRA. In that case, your tax bill will be based on the percentage of taxable and tax-free assets in all of your IRAs, even if you convert only one of them. For example, if you have $5,000 in a nondeductible IRA and $95,000 in a deductible IRA and convert $50,000 to a Roth, then only 5% of the nondeductible IRA funds, or $250, will be tax-free; you’ll owe tax on the rest.  If your employer offers a Roth 401(k), you can avoid this confusion because there are no income limits on contributions.” (Source: kiplinger.com)

You’re worried about lawsuits. 

The federal Employment Retirement Income Security Act (ERISA) shields 401(k) and other types of employer-sponsored retirement plans from creditors.

“If someone wins a judgment against you in a personal injury lawsuit, he can’t touch your 401(k) plan. IRAs don’t offer that same level of protection. They’re generally protected if you file for bankruptcy, but state laws vary with respect to other types of claims. California, for example, exempts the amount necessary to support you and your dependents in retirement. For physicians, protecting retirement savings from creditors “is a very big issue,” says Daniel Galli, a certified financial planner in Norwell, Mass.” (Source: kiplinger.com)

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