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Individual retirement accounts (IRAs) and 401(k) plans are the most common ways to save and invest for retirement. And for good reason. They're simple to set up and offer participants serious tax advantages.
Although their purpose is the same, they differ in a few key ways. For example, 401(k) plans are sponsored by employers while, as the name implies, IRAs can be started and maintained by an individual. Each has its own unique features, limitations and eligibility requirements. Here's what you need to know about the two plans.
What Is a 401(k)?
Many companies offer 401(k) plans as a benefit to help workers prepare for their retirement years. If yours does, you can use a 401(k) to save a portion of your pretax income in an account set up by your employer. The amount you contribute is automatically deducted from your paycheck before it reaches you, just like your taxes and Social Security contribution. When you enroll in the plan, you'll be presented a choice of where you would like to invest your savings, in the form of mutual funds or exchange-traded funds.
To encourage participation in 401(k) plans, some employers will match contributions up to a certain amount, often a percentage of your annual income. For instance, if your company offers a 3% match, it will contribute payments equal to your contributions up to 3% of your salary. Therefore if your salary is $40,000, your employer will match your contribution dollar-for-dollar up to $1,200 a year. After that, you can continue to save, but your employer will stop donating the extra funds. An employer may also choose to match only a portion of your contribution—50 cents per dollar you contribute, for instance.
Another thing to know about 401(k) plans is that they tend to reward company loyalty through a process known as "vesting." To completely own all contributions to your 401(k), including your employer match, you must become "fully vested" or risk losing a portion of it if you leave your job. Vesting rules vary by plan; some plans vest an employee immediately, some do so gradually, and others vest all at once after several years.
What Is an IRA?
An IRA is another way to save and invest for your retirement, but it's something you can do on your own instead through an employer. You would open an IRA for yourself at a bank, credit union, investment firm, broker or through a mutual fund provider. The different types of IRAs are as follows.
- Traditional: You can save pretax earnings and, as long as you qualify, those contributions will reduce your taxable income. So if your salary is $40,000 and you save $5,000, your taxable income will be $35,000. Your contributions are instead taxable only when you begin to withdraw the funds.
- Roth: With this IRA, you contribute after-tax earnings. Your contributions and the money they make are not treated as income when they're withdrawn, so will not be subject to income tax.
- Spousal: You can open a separate traditional or Roth IRA so a working spouse can make contributions in the name of a non-working spouse. This way, both partners will have their own retirement account to tap into when the need arises.
- Rollover: When you switch employers, you can transfer the money in a 401(k) plan to a rollover (traditional) IRA. While you may be able to remain with your employer's plan, the rollover IRA can reduce fees and provide you with greater control over your investments.
Smaller companies that don't offer 401(k) plans have special IRAs available to them:
- Simplified employee pension (SEP): This plan allows business owners to contribute to both their employees' and their own retirement savings. It follows the same rules as traditional IRAs, but only the employers can contribute, not their employees.
- Savings Incentive Match Plan for Employees Individual Retirement Account (SIMPLE): This IRA has similar benefits to a 401(k), and employees can add money to their account with elective contributions from their paycheck.
Key Differences Between 401(k)s and IRAs
Knowing the broad ways each plan differs can help you decide if one is a better option for you. The devil is often in the details, however, and it's important to understand how each plan may differ in its practicality based on your employer, savings goals, when you plan to retire and other things.
Eligibility and Contribution Limits
To participate in a 401(k) plan, your employer first must offer it, and not all do. If it does, you would decide on the amount you want deducted from your paycheck and can start saving right away.
A traditional or Roth IRA, on the other hand, may be opened by anyone who earns an income and has some savings to start the account with. Some financial institutions expect a minimum deposit of $1,000 or more.
There are also contribution limits to keep in mind. In 2020, you can contribute up to $19,500 to a 401(k) plan, though if you're age 50 or older you can make additional catch-up contributions of up to $6,500. With an IRA you can only contribute $6,000, or $7,000 if you're 50 or older.
Taxes and Distributions
Both 401(k) plans and traditional IRAs are funded with income that has not yet been taxed. The money will be subject to income tax when it's withdrawn, so you'll also have to plan for an IRS bill. Roth IRAs are funded with income that's already been taxed, so you won't be hit with an income tax bill later.
You can start to withdraw funds from a 401(k) plan and a traditional IRA at age 59½ (earlier than that and you'll be assessed a 10% penalty fee in most cases). You will be required to take distributions by age 72, and pay the taxes due. For a Roth IRA, however, as long as you keep the account for five years, there are no penalties for early withdrawal and you aren't required to withdraw the funds at a specific age.
With a 401(k) plan, you are limited to the investment options your employer chooses. You may choose to focus your 401(k) on one investment, such as a mutual fund, or to spread out your contributions between several investments that vary by type and risk level. It's often wise to diversify your portfolio to mitigate risk while also aiming for growth. Among your options:
- Bond funds invest in bonds or other debt securities. For example, the fund may hold U.S. Treasury bonds, municipal bonds, corporate bonds or mortgage-backed security funds.
- Stock funds invest in common stock of publicly traded companies. It might focus on U.S. large cap (shares in companies with a market capitalization value greater than $10 billion), U.S. small cap (values between $300 million and $2 billion), international companies, emerging markets or companies that invest in specific sectors, such as health care or natural resources. You may even be able to invest in a real estate investment trust (REIT), which is a fund that owns income-producing property like hotels, shopping malls, and apartment buildings.
- Balanced funds invest in a mix of bonds and stocks.
In contrast, an IRA provides a tremendous amount of freedom and doesn't limit you to the investment options your employer presents. You may use your IRA contributions to invest in the wide range of available funds, as well as individual stocks and bonds, and certificates of deposit. Depending on your level of comfort managing investments, this may be either a positive or a negative aspect of IRAs.
How to Choose Between a 401(k) and IRA
Clearly both 401(k) plans and IRAs have their own advantages and disadvantages, but either can be crucial to helping you start saving for your retirement early. The sooner you do, the more money you'll accumulate for the years when you're no longer working. Some rules of thumb when deciding where to put your money:
If a 401(k) plan is available to you, maxing out your allowable contribution can be wise (as long as doing so won't impact your ability to make your bill payments). A 401(k) plan allows for higher contributions than IRAs, and any matched funds your employer contributes are essentially free money.
Have extra money to contribute after you've maxed out your 401(k)? As long as you meet the eligibility requirements, you can also contribute to an IRA.
In the event that a 401(k) plan is not an option, choose the right IRA for you. In general, a traditional IRA is preferable if you expect that your tax rate will decrease when you retire, and a Roth will be better if you think your taxes will be higher in retirement. There is no income limit for a traditional IRA, but there is an income limit for a Roth IRA.
If you haven't yet entered the world of 401(k) plans and IRAs, they may be intimidating. In the beginning, remember the basics: Take advantage of your employer's plan if one is available, save as much as makes sense for your budget and future needs, and select your investments wisely. The tax benefits of using these vehicles will get you to where you want to go without overpaying Uncle Sam.