In the United States today, there are two major kinds of retirement plans. The first is the 401k, which is an employer-sponsored plan and the second is the IRA, which is an individual retirement plan. Both types of plans allow people to save money for use after they retire from the workforce, but that’s about as far as it goes for similarities.
When it comes to the 401k vs IRA, they both have pros and cons, so it’s really going to come down to your retirement goals when choosing which plan is right for you. Of course, if your employer does not offer a 401k, you could be limited to an IRA, but in the event that you have a choice between the two, it is important for you to understand the differences so you can make an informed decision.
A Description of the Plans:
Before you can start the 401k vs IRA comparison, you need to understand a little more about each type of plan. Compared to a 403b and a pension, the 401k is one of the oldest types of retirement plans in the country. It reached its popularity peak in the 1980s, however, most large companies still offer them today. The idea behind a 401k is simple: contribute a percentage of your income each pay period, allow that money to be invested and allow it to grow until you can access it when you retire.
The IRA is a newer type of retirement fund. The initials stand for Individual Retirement Arrangement (or Account) and it allows individuals to make pre-tax or after-tax contributions to an account that can only be accessed once you reach a specific age. You can only use cash or cash equivalents to fund your account. Depending on the type of IRA you get, you may be able to manage your own investment funds through your IRA.
401k vs IRA – Key Differences:
Now that you have a basic idea of each type of retirement account, here are the main differences between the two.
IRA – The amount you can contribute is based on the type of IRA you have (Traditional, Roth, Simple, Self-directed) and your annual income. For instance, if you make too much money, the amount you can contribute to your IRA will be reduced. Some IRAs do not allow you to make further contributions after the initial deposit, which can also limit your growth potential. Some IRAs allow pre-tax contributions, but most of them require contributions to be after-tax, although when you withdraw your funds, you will not have to pay taxes at that time.
401k – You can contribute up to your 401k plan’s maximum as long as you are employed by the sponsoring company. You make your contributions on a pre-tax basis and your income has no bearing on the amount you can contribute. The contributions are capped at a percentage of your income, so the more you make, the more you can contribute, up to a high maximum.
IRA – Your taxable income dictates how much you can contribute to an IRA. For example, in 2013, the limit is $5,500 if you are under age 50 and $6,500 if you are over age 50. However, that does not mean that everyone’s limit is the same. If you make too much money, you may not be able to contribute to your IRA at all. It also depends on your marital status and combined income levels. It is best to visit the Internal Revenue Service IRA webpage to make sure you are in compliance so you don’t end up paying fees and penalties for contributing too much.
401k – The maximum contribution levels for 401 accounts are much higher than IRA levels. In 2013, you can contribute $17,500 on an annual basis and that figure does not include your employer matching amount. This maximum will increase on a yearly basis to keep pace with inflation.
IRA – Only the Roth IRA will allow you to withdraw contributions at any time without a penalty. You cannot touch the account earnings until you are 59 ½ years old and have held the account for a minimum of five years, but when you reach those milestones, you can withdraw your funds at any time you want with no penalties or fees. If you contributed to your IRA on an after-tax basis, you won’t have to pay income taxes on your withdrawal either.
401k – You cannot withdraw your funds before the age of 59 ½ unless you pay a 10 percent early withdrawal fee. When you do withdraw your funds, whether you have reached 59 ½ or not, you will also have to pay income tax based on your current income tax bracket.
IRA – You can withdraw your funds at any age. There are also no minimums on the amount you can withdraw at a single time.
401k – You are required to receive minimum distributions at age 70 ½ years of age or pay a penalty.
IRA – You can withdraw $10,000 on a tax-free basis to assist with the purchase of a first house.
401k – You can take out a loan on your 401k that is equal to 50 percent of your account’s value or up to $50,000, whichever is less. You can use this loan for anything you want and you do not have to undergo a credit check to receive it. You pay yourself back with interest over a period of one-to-five years.
401k vs IRA: Who Wins?
When it comes to comparing a 401k vs IRA, it really depends on your needs. For the most part, a 401k is a better deal, especially if your employer matches your contributions up to a certain percent. However, if you would rather pay taxes on your contributions up front, an IRA might be a better option for you. Plus the flexibility of an IRA can really come in handy if you need to access your money quickly. However, the contribution caps of each plan should be a factor in your decision. You can potentially save a lot more money for retirement through a 401k, but you also have to contribute a lot as well. The point is, both plans offer advantages and disadvantages, so it’s up to you to analyze your circumstances and decide which one will help you meet your financial goals.
Image courtesy of FreeDigitalPhotos.net