401k vs IRA, Which one is better?

401k vs IRA, Which one is better? What is the advantage of a 401k over an IRA? Americans have several choices when it comes to saving for retirement. Two of the most popular options are a 401(k) plan and an individual retirement account (IRA). Assets in 401(k) plans totaled $6.7 trillion as of year-end 2020, according to the Investment Company Institute (ICI). 

With the ongoing economic crisis in the USA, workers are becoming increasingly concerned about just how much their 401k plans will be worth once the COVID-19 crisis is paid for, and some are being encouraged to consider an alternative method of retirement planning, an IRA.

401k plans are the traditional method of an employer-sponsored retirement plan, however, when people switch jobs they usually elect to roll over any accounts to their new employer, rather than withdrawing the money at that time.

Many people get the two plans confused, and it’s understandable given the similarities. Both offer the potential for tax-deferred investment growth (or tax-free growth if you opt for the Roth versions of either plan), tax breaks on contributions, and the ability to invest in assets such as stocks and mutual funds that have a higher potential return than savings accounts and bonds.

Below are the key ways in which a 401(k) and an IRA differ. We’ll also discuss which one may be a better fit for your personal retirement situation.

What is an IRA?, Definition and summary of IRA

An IRA is an individual retirement account that allows anyone with earned income (and even their spouses) to save for retirement on a tax-advantaged basis. Inside an IRA your money can grow tax-free or tax-deferred until you take it out at retirement. This special tax advantage allows your money to compound at a higher rate, letting you accumulate more over time.

The annual contribution limit to an IRA is $6,000 in 2022, though this figure usually rises every few years. Those over age 50 can contribute an additional $1,000 each year.

You can open an IRA at many different financial institutions, including banks and brokers, and you can buy several kinds of assets inside your IRA, including CDs, stocks, bonds, mutual funds, ETFs, and more. The best IRA accounts let you invest in potentially high-return assets such as stocks and stock funds.

Types of IRAs – Traditional IRA and Roth IRA

There are two major types of IRAs, and they differ in the tax advantages they offer you:

  • The traditional IRA can allow you to save for retirement on a pre-tax basis, meaning that you won’t pay taxes on any contributions you make to the account. The money inside the account can grow tax-deferred until you take it out in retirement, defined as age 59 ½ or later. When you withdraw the money, you’ll pay taxes at ordinary income rates. After age 72, you’ll be forced to take the required minimum distributions each year. The tax-deductibility of a traditional IRA depends on your income as well as whether your employer offers a retirement plan.
  • The Roth IRA allows you to save for retirement using after-tax money, meaning you won’t enjoy a tax break on contributions. However, you will be able to grow your money tax-free and then withdraw it tax-free in retirement, defined as age 59 ½ or later. Unlike the traditional IRA, you won’t be forced to take minimum withdrawals, and you can even pass the money down to your heirs tax-free. The Roth IRA has income restrictions, so if you make too much, you might not be able to take advantage of it.

Those are some of the largest differences between the two major types of IRA, but you’ll want to understand some of the other finer points of each IRA before deciding which is right for you.

What are the pros and cons of an IRA?

An IRA plan allows you to consolidate all your different retirement accounts into one IRA, which makes your life an awful lot easier from an organizational perspective. The process is very simplistic and there are no added taxes or penalties for moving your retirement plans around. An IRA also offers wider investment choices once your money is settled within it, and the costs are lower than with a 401k.

However, there are risks regarding creditor protection, as well as minimum distribution requirements being present.

With an IRA you have to be four years older to withdraw funds, and avoid a 10 percent early withdrawal penalty, than if you wish to do so with the traditional 401k plan.

What is a 401(k)?, Definition and summary of 401(K)

A 401(k) plan is an employer-sponsored retirement plan that allows a company’s workers to save for retirement on a tax-advantaged basis. In a 401(k), money can grow tax-deferred or tax-free until withdrawn at retirement. Employees can deduct a portion of their salary from their paycheck and have it invested in potentially high-returning assets such as stock mutual funds.

The annual contribution limit to a 401(k) is $20,500 in 2022, and this figure usually rises every few years. Those aged 50 and over can make a $6,500 catch-up contribution each year.

You may only open a 401(k) plan if your employer offers one. The plan will provide a fixed set of investments, often mutual funds, that you may invest in. These funds typically invest in stocks, bonds, or a combination of the two such as in target-date funds.

Many 401(k) plans also “match” a portion of the employee’s contributions to the account, providing “free money.”  An extra three to five percent of salary (sometimes more) is possible.

Types of 401(k) plans – Traditional 401(k) and Roth 401(k)

There are two major kinds of employer-sponsored 401(k) plans, and the key difference is the kind of tax advantage they offer:

  • The traditional 401(k) lets employees save for retirement on a pre-tax basis, meaning you won’t pay taxes on any contributions. The money in the account can grow tax-deferred until withdrawn at retirement, defined as starting at age 59 ½. When withdrawn in retirement, any funds are taxed at ordinary income rates. After age 72, you will have to take the required minimum distributions each year. Importantly, regardless of your income, a traditional 401(k) is always tax-deductible.
  • The Roth 401(k) lets employees save for retirement using after-tax money, meaning you’ll pay taxes on any contributions. However, the money in the account can grow tax-free and then be withdrawn tax-free in retirement, defined as age 59 ½ or later. After age 72, you will have to take the required minimum distributions. However, you can generally roll a Roth 401(k) into a Roth IRA with few or no tax consequences.

Those are the largest differences between the two kinds of 401(k) plans, but one employer’s plan may differ in important ways from another’s, so it’s important that you read the fine print on your plan to see what it allows does not allow.

What are the pros and cons of a 401k plan?

A 401k is generally considered safer, merely because it is a more-established long-term retirement planning strategy.

It allows your employer to directly pay into the account and these payments are easy to keep track of and check.

You generally only have to wait until you’re 55 years old to withdraw from your 401k and not receive an early withdrawal penalty.

Whereas, the fees are much lower as compared to an IRA because you have access to lower-cost institutional investment funds because of group buying power.

If your 401k is invested into company stock, you may be eligible for favorable tax payments on withdrawals

Is it better to have a 401(k) or an IRA?

With so many similarities, which one should investors choose? Well, if you can max out your contributions to both, then you won’t have to choose — while enjoying the full advantages each has to offer. But even though it’s permitted, many people can’t afford to do so.

Forced to choose, many experts believe the 401(k) is the clearly superior option.

“There is actually no comparing IRAs and 401(k)s,” says Joseph Auday, a wealth advisor with Steel Peak Wealth Management in Beverly Hills, California, citing the 401(k)’s higher contribution limit and the potential for an employer match. “If you’re not taking advantage of your 401(k), you’re missing out.”

However, advisors also stress that both plans remain valuable to retirement planning.

“IRAs and 401(k)s can both provide unique value to an individual’s retirement strategy, with key uses and specific pros and cons worthy of consideration,” says Michael Burke, CFP at Lido Advisors in Southbury, Connecticut.

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