401(k) vs. IRA — which of the two should have first dibs on the money you’ll set aside for your retirement? Today’s article shares the major differences between these two tax-advantaged retirement plans to help you make the right decision.
In this article:
- Difference Between IRA and 401(k)
- IRA or 401(k): Which Has Lower Contribution Limits?
- 401(k) or IRA: The Free Money Advantage
- How Withdrawals Are Treated in Each Plan
- Investment Options Available for Both Plans
- 401(k) vs. IRA: Which Should You Prioritize?
- Can I Have a 401(k) and an IRA at the Same Time?
401(k) vs. IRA: Which Should You Prioritize?
Difference Between IRA and 401(k)
In essence, 401(k)s and IRAs (Investment Retirement Accounts) are the same in that they’re both tax-advantaged retirement saving plans. However, a 401(k) is an employer-sponsored retirement plan while an IRA is not.
This means only employees can enroll and contribute to a 401(k). In contrast, anybody whose annual income falls within specified limits can own and contribute to an IRA.
While self-employed individuals can contribute to a self-employed or individual 401(k) plan, there’s a catch — they shouldn’t have common-law employees.
But while this is the main difference between the two, there are other important differences to consider.
IRA or 401(k): Which Has Lower Contribution Limits?
An important consideration when choosing which retirement saving plan to prioritize is contribution limits. The more an individual is allowed to contribute, the better it is for the account holder.
Both 401(k) and IRA plans are subject to annual contribution limits. However, 401(k) plans allow individuals to contribute more every year than IRAs.
For 401(k)s, the 2019 annual contribution limit is $19,000 while catch-up contributions are at $6,000 annually. For IRAs, the total annual contribution limit (Traditional and Roth combined) is only $6,000, with a maximum annual catch-up contribution of only $1,000.
What Is a Catch-Up Contribution? This is an additional amount that account owners aged 50 and above can contribute to a retirement plan, such as an IRA or a 401(k).
Aside from a lower contribution limit, IRAs have another limit: the individual’s modified adjusted gross income (AGI). Income limits on IRAs are as follows:
|Tax Filing Status||Modified AGI||Maximum Annual Contribution|
|Married and Filing Jointly OR Qualifying Widow/Widower||Below $193,000||$6,000 if younger than 50 years old; and
$7,000 if 50 years or older.
|Between $193,000 and $202,999.99||Less than the maximum annual contribution.|
|$300,000 and more||Ineligible to contribute.|
|Single, Head Of Household, OR Married Filing Separately (and not living with a spouse during the taxable year)||Less than $122,000||$6,000 if younger than 50 years old; and
$7,000 if 50 years or older.
|Between $122,000 and $136,999.99||Less than the maximum annual contribution.|
|$137,000.00 and higher||Ineligible to contribute.|
|Married, filing separately, and lived with a spouse during the year.||Less than $10,000||Less than the maximum annual contribution.|
|$10,000 or more||Ineligible to contribute.|
401(k) or IRA: The Free Money Advantage
Aside from higher annual contribution limits, another difference between a 401(k) and an IRA is free money.
Many 401(k) plans have a feature called the “employer match.” This means their employer sponsors a percentage of their 401(k) contributions using house money.
For example, some 401(k) plans’ have an employer match of 100% of an employee’s first 3% contribution and 50% of the next 3%.
This means employees who put in or defer at least 6% of their salary in an employer-matching 401(k) plan end up putting in 10.5% worth of their salary in their 401(k). This because their employers put in 4.5% worth of their salary on top of their own 6% contribution.
The employer’s matching contributions can be considered free money because it comes from the employer’s pockets.
On the other hand, IRA accounts don’t provide employer-matching since they’re not employer-sponsored retirement saving plans.
How Withdrawals Are Treated in Each Plan
When it comes to accessing one’s investment accounts, especially prior to retirement, an IRA offers more access than a 401(k).
With a 401(k), owners can borrow against their investment or make in-service distributions but all other access is restricted. That isn’t the case with an IRA.
Whether it’s a Traditional or a Roth IRA, individuals can access their investment accounts without restrictions. They can withdraw money or make distributions from their managed or self-directed IRA anytime.
However, individuals who withdraw money early from both IRAs and 401(k)s will have to pay taxes on them, even on Roth IRAs. On top of taxes, they’ll have to pay early penalties for early withdrawal of funds as well.
This is an important reason why it’s advisable not to withdraw funds from retirement accounts prior to turning 59 ½ years old or until retirement.
Speaking of Roth IRAs, early withdrawal of contributions aren’t subject to taxes because they’re after-tax contributions. This means the income used to make such contributions were already taxed, so such withdrawals aren’t taxed anymore.
However, early withdrawals of investment gains on such contributions are subject to taxes. Again, there’s a reason why IRAs and 401(k)s are called retirement plans — they’re meant for retirement, not before.
Investment Options Available for Both Plans
For individuals who prefer more investment options, an IRA will fit them better than a 401(k).
With an IRA, individuals can invest in different types of investment securities. These include stocks, mutual funds, cryptocurrencies, real estate, limited liability corporations (LLCs), and precious metals, among others.
With 401(k) plans, however, individuals can only invest in a select number of traditional investments, like mutual funds.
Having more investment options is essential for those who are seeking potentially higher returns for their future retirement income. However, with a high potential return on investment comes a higher financial risk as well.
401(k) vs. IRA: Which Should You Prioritize?
In the 401(k) vs. IRA debate, there’s no one-size-fits-all answer to this question. Each type of retirement plan has its own sets of benefits and limitations.
- 401(k) — 401(k)s allow individuals to contribute more money every year to their retirement plans, enabling them to save more. This is because a 401(k) has a higher contribution limit and offers the employer-matching scheme. It also doesn’t qualify individuals who can contribute to a retirement plan based on modified AGI or adjusted gross income.
- IRA — While IRAs have a much lower annual contribution limit, don’t have employer-matching schemes, and allow access only to individuals with lower annual incomes, they provide more investment options than 401(k) plans. And when financial emergencies arise, individuals can easily (but subject to taxes and penalties), withdraw their funds.
Ultimately, the individual’s retirement investment goals and strategies will determine which to prioritize.
Can I Have a 401(k) and an IRA at the Same Time?
Individuals who want the best of both worlds can do so. The IRS doesn’t prohibit having IRAs and 401(k)s at the same time as long as the individual falls within the parameters and limits of both plans.
However, many people prefer to max out their 401(k)s first before putting money in IRAs. And normally, they invest IRAs into higher-risk assets that aren’t available in most 401(k) plans.
In the 401(k) vs. IRA debate, which of the two is the clear winner when it comes to investment priorities? The truth is, the answer isn’t really as clear or cut and dried as anybody would like it to be.
People need to consider their overall retirement saving and investing goals and preferred strategies first. Evaluate which benefits of 401(k)s and IRAs are best suited for those goals and strategies.
This can help you wisely prioritize the right type of retirement savings plan that’ll work for you.
Based on your retirement financial goals and strategies, will you prioritize 401(k) or IRA plans? Let us know in the comments section below.
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