401k vs. IRA vs. Roth IRA
By, Alexandra DeLuise
Retirement options can be overwhelming.
How can you choose between a 401k vs. IRA?
What is a 401k anyway?
What’s the difference between a traditional IRA and a Roth IRA?
Putting aside money for retirement is a good strategy, but it’s important to use the right type of retirement savings account for your personal financial needs in order to make the most of your pre-retirement years. That’s why it’s a good idea to become familiar with the benefits of a 401k vs. IRA retirement account benefits.
What Is A 401k?
A 401k is a retirement plan that is offered through an employer (although those who are self-employed can offer themselves a 401k through their business). This means that the types of investment options are dictated by the employers as well. So, 401k investment choices might be more limited than those offered by an IRA.
Those with a 401k can contribute up to $18,000 per year until they reach age 50. After that point, the maximum contribution goes up to $24,000. These contributions are pre-tax which means they’re taken out of your paycheck before taxes are calculated.
If you make $5,000 per month and contribute $1,000 to a 401k, you’re only taxed on $4,000. If you contribute the maximum amount you’ll slash your tax payments.
With pre-tax dollars and growing investment balances, this is a great way to build your retirement fund. And taxes on the investments aren’t due for many years, or never in the case of a Roth IRA.
If you find yourself deciding between a 401k vs. IRA, you should know that a 401k allows a much higher contribution limit than is allowed for an IRA. You can only contribute $5,500 to an IRA or $6,500 if you’re older than age 50.
Free Money from Your Employer
Employer matching is one of the biggest selling points to the 401k. Although this is not required, many employers offer to contribute additional funds to 401ks. Many employers match what their employees contribute, so if you contribute 3% of your paycheck and your employer adds an additional 3%, you’ll can actually be adding 6% of your salary to your 401k.
Some employers go above and beyond by contributing more than an equal match if employees max out their 401k every year. I’ve heard of an employer offering to contribute the equivalent of 9% of the employee’s salary if the employee made a contribution of at least 6%.
If you already have a 401k, you can get a free Blooom retirement account review. Blooom offers a quick look at your 401k investments and helps you find out if you’re choosing the best funds with the lowest fees. I tried it and it was very quick.
If you don’t make the minimum contribution to receive employer matching, it’s almost like throwing away free money . If you can afford it, contribute at least as much as the maximum your employer will match to get the most benefit!
If you’re still wondering “what is a 401k, and are these rumors about them true?” you might want to check out these 401k myths!
Is a 401k The Same As An IRA?
Definitely not! While there are some overlapping benefits, IRAs are distinct from 401ks for a few important reasons.
For instance, IRAs have much lower limits on how much any individual can contribute each year. The maximum contribution is $5,500 per year for individuals who are under 50 years of age; after 50, an extra $1,000 each year in “catch-up contributions” can be made.
When it comes to tax status, you have several options with IRAs. Traditional IRAs are usually funded with pre-tax dollars, which makes them appealing in the moment. This is the only time the question “is a 401k the same as an IRA” can be answered with a resounding “yes!”
Then there’s the non-deductible IRA, funded with after tax dollars
Roth IRAs are funded with money that you’re already paid tax on. Yet, the icing on the Roth IRA cake is that when you withdraw money from your Roth IRA, the taxes for these funds have already been paid. And, Roth IRAs are great because you don’t pay tax on any withdrawals from the account, as long as the money’s been invested for at least five years and you’re older than age 59 1/2.
Of course, the above Traditional IRA benefit of pre-tax contributions is based on assumptions that tax rates will be higher in the future.
There are pros and cons to both 401k and IRA options, so make sure to do a lot of reading on which one is better to max out first (or at all!).
Another selling point for the Roth IRA in the 401k vs. IRA debate is that 401k withdrawals are mandatory (and taxed!) at age 70 1/2, while there are no required distributions for the Roth IRA. If you have lucrative investments in your Roth IRA, having as much money as possible earning interest, dividends and capital gains can be a massive selling point.
So, In The 401k vs. IRA Debate, Which Should I Choose?
Let’s recap some of the major selling points and drawbacks for each.
A 401k is a great option because:
• The contributions are tax-deductible, so you might save money at tax time!
• The maximum contributions are very high, so those who feel behind in their retirement plans can rev up their savings quickly.
• These accounts usually (although not always) offer employer matching, so extra money will be contributed toward your future on your behalf.
Are you on track for retirement? Read; Fidelity’s Retirement Saving Guidelines
Of course, there are cautions as well: You will need to make mandatory withdrawals once you hit age 70 1/2, for example. Additionally, since these accounts are provided by employers, you have limited investing options and are stuck with the package your employer offers. Although, some employers are now offering Roth 401ks, funded with post-tax dollars and higher contribution limits than typical Roth IRAs.
IRAs have quite a few benefits as well:
• Investors can choose from a few different types of IRAs, including Traditional IRAs (tax-deductible) or Roth IRAs (post-tax investments).
• Most IRAs require distributions to begin at age 70 1/2, just like 401ks. However, Roth IRAs do not have this requirement.
• IRAs can be opened even without an employer, as long as you or your spouse are working. This makes them more customizable.
• IRAs typically offer greater investment choices.
A potential downside of IRAs is that the maximum contributions are significantly lower than the maximums of a 401k. IRA deductibility phases out above certain income levels.
There’s also the potential for overwhelm. While 401ks are fairly straightforward in terms of set up—they’re a set-it-and-forget-it type of investment for some people, though we can’t recommend that!—you have a lot of options for IRA types, including SEP IRAs (for the self employed), which offer different benefits than the Traditional and Roth IRAs mentioned here.
Regardless of which option you choose, it’s important to understand how to get the most out of your investments. This includes learning about the different tax benefits of each, and the ways these choices will affect your retirement.
And, don’t forget to get a free 401k retirement account check up with Blooom. It’s very quick and could save you fees and improve your returns.
Alexandra DeLuise is a freelance writer and teacher who draws on her banking background to write actionable financial tips for real people.
Disclosure: Please note that this article may contain affiliate links which means that – at zero cost to you – I might earn a commission if you sign up or buy through the affiliate link. That said, I never recommend anything I don’t believe is valuable.