401(k) vs. IRA: Pros, Cons, and Key Differences
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Building a nest egg for retirement is like planting a tree.
If you plant it early enough and regularly give it water, you can expect a full-grown tree by the time you’re ready to retire.
But if you want that tree to grow as large as possible, you need to plant it in the right kind of soil. In other words, you need to choose the right kind of retirement plan before you start contributing. For most consumers, that means picking between a 401(k) vs. IRA.
The details of each type of retirement account may get a little complicated, but choosing the right fit is actually pretty simple. Here’s what you need to know.
|Traditional 401(k)||Roth 401(k)||Roth IRA||Traditional IRA|
|Limits||$19,000 and an extra $6,000 for workers over 50.||$19,000 and an extra $6,000 for workers over 50.||$6,000 and an extra $1,000 for workers over 50.||$6,000 and an extra $1,000 for workers over 50.|
|Key Pros||Large contribution limit.|
Possibility of an employer match.
|Bigger contribution limit than IRAs.|
Withdrawals are tax-free in retirement.
|Tax-free retirement withdrawals.|
No RMDs in retirement.
|Contributions are tax-deductible.|
|Key Cons||Fund options may be limited.||No tax deduction.|
RMDs are required.
|Contributions are limited for those above a certain income.||Contributions limited to $6,000 a year.|
Withdrawals are taxed.
|Best For||Employees with a company match and 100% vesting.||Young workers who want to save more for retirement.||Those who want to start investing but don’t have access to a 401(k).||High-earners looking for more deductions or self-employed workers without access to a 401(k).|
Individual Retirement Account (IRA)
An Individual Retirement Account (IRA) is a retirement account that any individual can contribute to. Any money contributed to an IRA must be earned while working a job. There are two types of IRAs, Roth and traditional.
Both types of IRA have the same maximum annual contribution limit of $6,000, and both allow an annual catch-up contribution of $1,000 for those 50 or older. IRAs are popular because customers can pick exactly what they want to invest in. They can choose between individual stocks, mutual funds or target date funds.
A traditional IRA, like a traditional 401(k), allows investors to deduct contributions on their taxes. If you save the maximum $6,000 in your IRA, you can deduct $6,000 from your taxable income.
The tax deduction associated with a traditional IRA is the main advantage over a Roth IRA. Consumers with high incomes or business owners who want to decrease their taxable income will benefit the most from a traditional IRA. Because traditional IRA users get a tax break now, they have to pay income tax on their traditional IRA withdrawals in retirement.
A major drawback to traditional IRAs is their required minimum withdrawal (RMD). An RMD is how much you’re legally obligated to withdraw from your traditional IRA every year after you turn 70.5. The annual amount changes based on your total traditional IRA balance, your age, if you’re married, who your main beneficiary is, and how old your spouse is.
Let’s say you have $1,000,000 in your traditional IRA. You’re 71 years old and your spouse is also 71. According to the Vanguard RMD calculator, your RMD for 2019 would be $51,282.
Whichever investment company you use to hold your traditional IRA should be able to tell you how much your RMD is for each year. Not taking your RMD or taking less than is required will result in a penalty that’s 50% of the difference between what you withdrew and what your RMD was.
A Roth IRA is a retirement account that provides tax-free withdrawals in retirement. Investors who contribute to a Roth IRA won’t receive a tax break while they contribute, but they won’t have to pay taxes on their withdrawals later on.
Roth IRAs also don’t have RMDs and are the only retirement account on this list without them. The Roth IRA is extremely popular because it allows investors to avoid taxes in retirement while they’re living on a fixed income.
Unfortunately, the IRS limits Roth IRA contributions to those who earn below a certain amount. Those filing single can contribute to a Roth IRA if they earn below $122,000 a year. Contributions start to phase out for individuals earning between $122,000 and $137,000. Anyone making $137,000 a year or more isn’t eligible to contribute to a Roth IRA.
Married couples filing jointly who make less than $193,000 a year can contribute to a Roth IRA, and contributions begin to phase out for incomes between $193,000 and $203,000. Couples making more than $203,000 are excluded from contributing to a Roth IRA.
A 401(k) is an employer-sponsored retirement account available to employees as a company benefit, used to encourage employees to save money for retirement. Like health insurance and paid time off, individual companies have the right to decide if they want to offer a 401(k).
There are two types of 401(k)s, Roth and traditional. Like with IRAs, a traditional 401(k) has tax-deductible contributions and a Roth 401(k) has tax-free withdrawals in retirement.
The most important advantage with a 401(k) is the possibility of a company match. Some employers will contribute money to their employees’ 401(k) account. This is basically free money that an employee can use for retirement.
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Matching contributions vary based on company policy. Some companies require that employees contribute a certain amount before the employer match kicks in. Others contribute to 401(k)s without an employee requirement.
Many companies have a vesting period, which dictates when employer contributions become the employee’s legal property. A five-year graded vesting schedule means an employee has to stay five years to earn 100% of the employer contributions. If they leave two years in, they’ll earn 40% of the contributions and forfeit the rest.
401(k)s come with a huge annual contribution limit. That limit is $19,000 in 2019, with those 50 or older able to contribute an extra $6,000 a year. That makes it one of the largest contribution limits available for all retirement accounts.
One disadvantage of 401(k)s is that the employer has complete control over what funds are available. Companies can offer a small handful of funds or a large variety. It’s also common for 401(k) funds to have high fees that eat away at investor profits. The only way to avoid bad fund options is to petition your HR department to offer a better variety.
Another drawback is the vesting schedule, which can keep an employee tethered to a job longer than they want.
A traditional 401(k) can decrease your taxable income and reduce how much you pay in taxes. That’s why people with high incomes opt for a traditional 401(k) in lieu of a Roth.
Employees will still owe taxes on withdrawals. Like traditional IRAs, individuals 70.5 or older must start taking RMDs.
The Roth 401(k) is a relatively new product, and many employers still don’t offer them. It combines the best aspects of a Roth IRA and a 401(k) – the tax-free withdrawals in retirement offered by a Roth IRA and the higher contribution limit of a 401(k).
Unlike Roth IRAs, Roth 401(k)s do have RMDs when the retiree turns 70.5. These can be avoided by converting the Roth 401(k) into a Roth IRA. Make sure to do this before you turn 70.5.
Opening Both an IRA and 401(k) May Be the Best Option
Choosing between an IRA and 401(k) can seem difficult to a novice investor, but there’s no wrong decision here. There are benefits to both plans, and many investors find it useful to have an IRA and 401(k). If you’re struggling to decide between a Roth or traditional plan, you can also have one of each and contribute to both.
Some investors will contribute enough to a 401(k) to earn a company match and then open an IRA. For example, if your employer contributes 50% of what you put in, up to 6% of your salary, you can contribute that amount to get the company match. If you still have money left over, you can open an IRA and put any extra funds there.
The only truly wrong decision is to wait and delay picking a plan because you’re not sure which one is the best. When it comes to saving for retirement, the most important thing is contributing early and often.
If you’re having trouble deciding on your own, you can hire a financial planner to explain what your options are and what makes the most sense. They’ll be able to design a strategy that fits your specific situation.