If you're exploring retirement savings options, you've probably considered opening a 401(k) or an Individual Retirement Account (IRA). But what’s the difference between them? What are the benefits of an IRA? What are the benefits of a 401(k)? And is one better than the other?
In this guide, we'll answer these questions and more and help set you up for a secure and happy retirement.
IRA and 401(k) defined.
What is an IRA – and what is a 401(k)?
A 401(k) is a retirement savings account that is offered by an employer. Once you meet the eligibility requirements, you may sign up to have a certain amount – typically a percentage – deferred (deducted from your paycheck) and put into the account.
Like a 401(k), an IRA is a unique, retirement savings account where contributions are either tax deductible or contributed after tax. Unlike a 401(k), contributions to an IRA are made personally and not through payroll deduction.
401(k) vs IRA
So, what’s the difference between a 401(k) and an IRA? As it turns out – not much.
Both are retirement accounts that rely on investing accrued funds, and both have annual contribution limits. The main difference is how you acquire these accounts.
A 401(k) is offered through your employer, while an IRA is usually a separate account you open through a bank or broker.
As you peruse IRA and 401(k) offerings, you may also notice that 401(k)s will have higher contribution limits and that you may have more freedom and options when choosing your investment strategies with an IRA.
Traditional vs. Roth
Both a 401(k) and an IRA have two options – Traditional (called Pre-Tax in a 401(k)) and Roth.
A pre-tax deferral into a 401(k) means your contributions will not be taxed before the contribution is deposited into your account. Contributing to a Traditional IRA could be a way to get a tax deduction on the contribution, but this all depends on your total tax outlook. While it means you can put more aside early on – and benefit from the increased compounded interest – your post-retirement paycheck may take a hit if taxes have increased.
A Roth deferral to a 401(k) is completed after taxes have been paid and there is no tax deduction for a Roth IRA contribution. While you'll see a little less going into your account each paycheck, you won't have to pay taxes when you complete qualified withdraws after retirement.
How to use an IRA or 401(k) to save for retirement
In the case of a 401(k), your employer may elect to "match" funds that you have contributed up to a certain amount. That means, essentially, you can get 'free' money going into retirement savings – and that adds up over the years.
A 401(k) is a type of retirement savings that moves with you if you change jobs. It's easy to roll over your balance into a new account or an IRA – meaning your savings are not dependent on your job. So, no matter what the job market throws at you, you can rest easy knowing that your future is secure.
Early withdrawal options
Both a 401(k) and an IRA usually penalize account holders who withdraw too early. Typically, you have to be retired or be of a certain age before you can withdraw funds from these accounts. Withdrawing money too early can result in a 10% penalty. Plus, you'll be cutting into your retirement savings – so many financial experts advise against early withdrawal.
There are exceptions in which the 10% penalty can be waived, but you will want to consult a tax professional before you choose to take an early distribution. These type of withdrawals are taxable in the year they are completed. Also, some of the 401(k) plans do offer a loan feature.
Since there's such a steep penalty if the withdrawal does not meet the criteria, you'll want to make certain you qualify. As stated above, please consult a tax professional or learn more about hardship withdrawals on the IRS’s website.
When to contribute to a 401(k) over an IRA, or vice versa
Contributing to a 401(k) or an IRA is nearly always a sound financial decision, especially if your employer offers matching for your 401(k).
Often, people combine an IRA with a 401(k) to maximize the amount they're saving for retirement. Since both accounts have limits, people often maximize what they're putting into a 401(k), including company matching, and then move extra contributions to an IRA – at least until they hit that contribution limit, as well. In fact, financial advisors often recommend contributing to both an IRA and a 401k to ensure a stable financial future rather than choosing one over the other.
When to start contributing to an IRA or 401(k)
Financial experts also recommend that you start contributing to an IRA or 401(k) as soon as possible because that money quickly adds up.
While experts recommend maxing out your contributions, or at least contributing 10 percent of your income – whichever comes first – how much you choose to put back is up to you. Start by writing down your retirement goals to help guide you. Do you want to stop working completely? Work part-time? Do you plan to have all your debt paid off?
These things can inform you on how large a percentage you should put back each paycheck and help you determine a strategy that works for you.
If you need a sounding board for your retirement goals, chat with one of our attentive Private Wealth Advisors, who can help you craft a plan to set you up for the retirement of your dreams.