Smart Investing: IRA Versus 401(k)

July 8, 2022

The two most common options for retirement plans are an employer-supported 401(k) and an individual retirement account (IRA). Both options are considered smart planning for the future but, when it comes down to it, how do you know which one to choose? If you ask the experts, the answer is both. Most employer-supported 401(k)s only replace around 80% of your annual income – and that’s if you started early and had a reasonable match rate. So how do you make up the other 20 to 30%? That is precisely why it’s smart to have both a 401(k) and an IRA. Let’s take a look at what you should know about the differences between an IRA versus 401(k).

1. Contributions

No matter which type of retirement plan you choose, there will be limitations on the amount you can contribute each year. The IRS sets these limits. In 2019, you’re allowed to contribute $6,000 total to any traditional or Roth IRA if you are under the age of 50. If you’re 50 or older, you may contribute $7,000. (To learn more about the differences between a Traditional IRA and a Roth IRA, see the breakdown chart on our website.)

You can also choose how frequently you contribute to your fund. You can add to your IRA monthly, quarterly, or in one lump sum as long as you do so before April 15th. As for a 401(k), the limits this year are $19,000 if you are under 50 years old and $25,000 if you are 50 or older. These funds are pulled from each paycheck. The total amount will depend on both your contributions and the employer’s match rate.

2. Tax Benefits

Any pre-tax contributions to Traditional IRAs could reduce your taxable income. It is a tax deduction. The rules on whether you can use your contribution as a tax deduction may vary by situation. The account is tax-deferred. This means that the assets and growth cannot be taxed until you begin withdrawals. On the other hand, any money put into a Roth IRA is considered after-tax, so this IRA has no instant tax benefits.

But, if you meet specific criteria, you may not have to pay taxes on your withdrawals. In other words, you will not pay taxes on the growth over time. (You can read more details about the tax benefits of Traditional IRAs versus Roth IRAs on our website.) As for your 401(k), contributions to your plan reduce your overall taxable income. Taxes will instead be taken out when you withdraw from your plan.

3. Fees

Fees are a significant differentiator when it comes to retirement plans. Some fees are present for both plans, such as an administrative fee. This fee pays for the recordkeeping and reporting to the IRS. You can choose your own IRA administrator. The three options are a self-directed IRA specialist, a bank, or a brokerage. You will have the most control over your plan by going with a self-directed IRA. By choosing an IRA, you can find someone you trust for the price you agree to.

For a 401(k), your employer will choose the administrator because they are sponsoring the plan. You can find a statement of fees charged, services performed, and investment choices on the annual fee disclosure. You can also ask your company about these details upfront if they are not provided.

4. Withdrawals

A blanket rule for most 401(k)s and traditional IRAs requires you to be 59½ before you can withdraw funds with no penalty. The typical penalty is 10%. Roth accounts have a few other rules that apply to withdrawals that can help you avoid paying income taxes on your withdrawals. Your rate may fluctuate depending on what tax bracket you are in. There are some exceptions to this rule, but they depend on whether you’re withdrawing from a 401(k) or an IRA. You can view these exceptions here.

As for a Roth IRA, the regulations are different because you have already paid taxes on your contributions. You can make withdrawals without paying taxes at any time. Conversion dollars may be subject to the 10% penalty if you withdraw before age 5 ½ and you don’t meet the exception criteria. To gain tax-free distribution of your earnings, you must meet one of the following criteria: disability, death, purchasing a primary residence over $10,000, or turning 59½. You also must have also had your Roth IRA for at least five years. If you meet one of these criteria and the five-year minimum, you qualify to withdraw tax-free.

When it comes to an IRA versus 401(k), the most important thing is that you are well-informed about the different options available to you. That way, you can choose the retirement plan that makes the most sense for your situation and retirement goals. If you already have one or multiple employer 401(k)s and want more control over them, you can even roll them over into an IRA or even numerous IRAs. Remember, it is never too early to start planning for retirement. Talk to a trusted self-directed IRA custodian today.