401(k) vs. IRA: Which Should You Choose
401(k) or IRA. Both are great options to begin saving for retirement. But which one is right for you? Let’s examine each type of retirement plan.
Simply put, a 401(k) is a retirement plan that is managed by your employer. Employees elect to contribute a certain amount of money from their pay each pay period towards the 401(k).
The money you contribute to a 401(k) is typically pre-tax dollars. It’s a tax-deferred retirement plan. In other words, you don’t pay tax on the money you contribute to the 401(k). Instead, you’ll pay taxes when you begin taking distributions. It will be taxed like any other source of income provided you’re over age 59 and 1/2.
Most 401(k) contributions are deposited into a variety of mutual funds chosen by your employer, customized to meet your risk tolerance. Younger people who are still decades away from retirement might opt for an aggressive risk portfolio. With high risk comes high reward. However the older you get, the less risk you’ll want to take with your investments.
As of 2020, 401(k) participants can contribute up to $19,500 per year, and can make catch-up contributions of an additional $6,500 for people aged 50 and up.
The big upside to 401(k)s are due to being managed by employers. To entice you to stick around at your job, many employers will match the contributions you make to your 401(k) up to a certain percentage of your salary. But beware; you may be required to stay at your employer for a certain period of time or risk losing the matching contributions when you leave.
An IRA, which is pronounced by spelling out the letters I-R-A, and not eye-rah, stands for Individual Retirement Arrangement.
Unlike 401(k)s, IRAs are not tied to a specific employer. IRAs are managed by a custodian, typically a bank or a brokerage firm. Also unlike 401(k)s you can contribute more than just money to an IRA. Examples of other assets you can include are CDs, stocks, bonds, and even real estate.
Similar to a 401(k), contributions to a traditional IRA are tax-deferred. You only pay tax once you take the money out of the IRA.
The other major difference is the contribution limits. As of 2020, the annual contribution limit for an IRA is $6,000 per year. People age 50 and over can make catch-up contributions of an additional $1,000 per year.
But while the contribution limits are lower, many IRAs offer more options for investing your money than the basic mutual funds offered by your employer’s 401(k).
Traditional vs. Roth
Up until now, we’ve talked about traditional 401(k)s and IRAs. The traditional version of these retirement accounts make them tax-deferred.
As we’ve established, you contribute pre-tax dollars to your traditional retirement account. The earnings from your investments grow tax-free until you retire and begin taking distributions after age 59 and 1/2.
Roth IRAs and Roth 401(k)s work the opposite way. You contribute after-tax dollars to a Roth retirement plan. Meaning you’ve already paid tax on the money you’re putting into the account. That money is invested just like in their traditional counterpart. But since you paid the tax on the money you put into the plan, any withdrawals are tax-free.
Roth IRAs can be found nearly anywhere you would open a traditional IRA. Roth 401(k)s are a fairly recent development and are gaining popularity. But they are not offered by all employers at this time.
So Which One is Right for Me? IRA or 401(k)?
Our advice is if your employer offers a match to your 401(k), maximize your contributions to your 401(k) to earn as much match as possible. If your employer doesn’t offer a match, stick to the IRA.
Or why not both? It’s a common misconception that you can’t have both a 401(k) and an IRA. You certainly can maintain both at the same time, and can help you maximize your retirement savings each year.
Ultimately it’s up to you. Some people like the idea of not having to pay tax when they retire and opt for a Roth IRA or Roth 401(k). Others would rather avoid the tax now and worry about it down the road and stick to a traditional retirement plan.
Either way, don’t wait to start planning for retirement. The sooner you start, the better off you’ll be.