IRA vs. 401(k): Which Should You Choose?

Investments ira-vs-401k

If you’re looking to get tax benefits on your retirement savings, an IRA and 401(k) are both great choices as you won’t pay taxes on your investment growth. The main difference between the two is that a 401(k) must be set up by an employer and is a pre-tax investment, whereas an IRA is set up by an individual with after-tax dollars.

When it comes to saving for retirement, smart financial planning is a must. Below, we’ll walk you through how IRAs and 401(k)s work, plus the pros and cons of each.

IRAs

An individual retirement account (IRA) is a tax-deferred retirement savings account set up by an individual rather than an employer. There are several types of IRAs to choose from and many allow account holders to own multiple assets within the account, such as stocks, bonds, real estate, and CDs.

Traditional IRA

A traditional IRA gives you a tax deduction upfront on your contributions and earned interest. You won’t be required to pay taxes on your investment gains until you withdraw your investment, and the amount you pay in taxes will be based upon the distribution age requirements.

Roth IRA

A Roth IRA doesn’t allow you to deduct your contributions. However, since your account is funded with after-tax dollars, you won’t pay taxes on your investments or gains when you withdraw in the future, as long as you meet the age distribution requirements and have held your account for over five years.

SEP IRA

If you’re self-employed or own a small business, then a simplified employee pension (SEP) IRA may be a good fit for you. This retirement account offers tax breaks for self-employed individuals and business owners to save for the future.

401(k)s

A 401(k) is a tax-deferred retirement savings account that is set up by an employer. Because this is a company-controlled investment, you have a smaller investment selection than you would with an IRA. In a traditional 401(k) you’ll invest pre-tax dollars, meaning you can reduce your taxable income as you invest, but you’ll pay taxes on your contributions when you withdraw them.

Tax-deferred 401(k)

A tax-deferred 401(k) allows you to save taxes today and save for retirement. Workers set aside a portion of their pay before federal and state income taxes are withheld, which allows them to lower their taxable income and pay less income tax.

Roth 401(k)

In a Roth 401(k), your funds are removed after taxes, meaning you are paying taxes as you contribute and won’t have to pay taxes when you withdraw your investment.

Comparing IRAs and 401(k)s

If you’re having trouble deciding between an IRA and a 401(k), we have good news for you: you can have both! So what are the differences between the two?

A 401(k) typically offers an employer match, meaning you invest more money than you contribute. The most common match plan is 50 cents on the dollar, up to 6% of the employee’s pay. All of the investments in your 401(k) are pre-tax investments, meaning that when you withdraw your contributions, you’ll owe taxes on them. Because your 401(k) is maintained by your employer, you have less of a say in your investments.

While IRA benefits and restrictions can vary, this individual retirement account typically holds after-tax investments, so you will pay no taxes on your money if you withdraw it after age 59 and a half. You’ll have access to a much larger investment selection with your IRA and can grow investments on stocks, bonds, real estate, and CDs.

This chart helps break down the differences between a Roth IRA and Tax-deferred 401(k):

Roth IRA Tax-deferred 401k
How it works Holds after-tax investments and doesn’t require tax payments if you withdraw after age 59 ½ Employer-sponsored and holds pre-tax investments that lower your taxable income
Are the contributions taxed? Yes No
Contribution limits Contribute up to $6,000 per year (those ages 50 and older can contribute $7,000) Contribute up to $19,000 per year (those ages 50 and older can contribute $25,000)
Are there penalties? Yes. You’ll be penalized if you withdraw before age 59 ½. Yes. You’ll be penalized if you withdraw before age 59 ½.
Are you required to make withdrawals at a certain age? No, you are not required to withdraw money at a certain age. Yes. After age 70 ½ you’re required to withdraw a certain amount.
Pros
  • Access to a large investment selection
  • Contributions can be withdrawn anytime
  • High annual contribution limit
  • Eligibility is not limited by income
Cons
  • Lower contribution limits
  • No immediate tax benefit for contributing
  • Employer controls plan and investment costs
  • Distributions are taxed

What Is Best for You?

If you’re still wondering which retirement savings account is best for you, we’ve got you covered with these frequently asked questions and answers.

Should I take advantage of my company’s 401(k)?

If your company offers a 401(k) with a company match, you should set up your 401(k) and contribute the match amount. Why? It’s free money that your employer is giving you for retirement, so you should take advantage of it.

What if I have leftover funds to invest after the 401(k) match?

Once you’ve met your company’s 401(k) match, we recommend you start taking a look at IRA options to diversify your investment portfolio. Having multiple retirement savings accounts isn’t for everyone, though. If the thought of having two is overwhelming, you can stick to the 401(k) and contribute more than your company match, although there are contribution limits.

How do I decide which IRA to open?

If you do decide to diversify your investments, you’ll need to decide which IRA you’d like to open. Remember that your Roth IRA will be after-tax dollars, so you won’t pay any taxes when you withdraw your investment and gains in retirement. Since your traditional IRA functions more similarly to a 401(k), you will be able to reduce your taxable income today, but you’ll pay taxes on your investment and gains in the future.

Sources:

Chris Hogan

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